Sunday, March 29, 2009

Capitalism and Consumption

I am aware that, in the current climate, a defence of capitalism and consumption will not go down well with everyone. An interesting question on the subject was added to my last post by Lemming, a regular commentator. I will quote his question, as others are asking similar questions, such as whether there is enough resource for endless growth:
Can you design a system of capitalism which doesn't rely on economic growth to function? (Or is this simply a contradiction in terms?)
There is a fundamental problem in capitalism with respect to endless growth. Regular readers will know that I am somewhat cynical about the modern environmental movement, but I accept that there is a real problem in the medium to long term with resources. In the short term there is also a problem, but rather this is a matter of output rather than absolute limits on resource. In light of this, Lemming is asking a very pertinent question with wider implications. However, for the purposes of this post, I will ignore the longer term issue of resource, as this is a question that is too complex to cover in this post.

Another problem associated with economic growth is the relentless growth of advertising and media representation of society, in particular the lifestyle advertising that seems to encourage so much consumption. It is a matter of controversy how much advertising is a reflection of society, and how much it might 'make' society, and again I will not address this question here due to the complexity of the subject.

On the other hand Lemming's question does raise a more fundamental question. If endless economic growth is a problem it would imply that, at some point, economic growth should be frozen. This is a difficult idea, as it raises the question as to when exactly, or at what stage of development, growth should be stopped.

If we can think back to the world twenty years ago, would that have been an appropriate time to have frozen growth, or should we say that we should freeze further growth now? It is only when we ask such questions that the nature of the problem becomes clear. If we were to imagine that the world had frozen in terms of economic growth twenty years ago, then we must accept what the world would be like today without such growth (we will ignore the current economic mess for the sake of illustration - as the crisis is not a result of economic growth but the way in which the growth has taken place).

A simple example to illustrate the question is to ask whether we think that we should have foregone the development of fMRI equipment - which have allowed considerable improvements in our understanding of the brain, as well as being used to treat a range of medical problems. As soon as the innovation was introduced, it would have been a spur to economic growth, as it created a whole new industry and no doubt many offshoots. It might be argued that this is a very narrow and selective example but, if it were not for the massive advances in computing (for example), then the fMRI process would never have been possible.

The point in this example is that it is very difficult to separate out 'good' economic growth from 'bad' economic growth. For example, the boom in consumer purchases of computers has no doubt created significant economies of scale in the computer industry, as well as being an ongoing spur for continued innovation. The economies of scale and innovations that resulted from this ongoing consumption will have fed into many areas, even possibly fMRI scanning (e.g. cheap displays or processing power) and it is difficult to propose that such improvements do not have 'worthy' outcomes. As such, the boom in consumption of computers will have indirectly contributed to the development of fMRI, as well as many other innovations.

On the other hand there is a general backlash against the relentless consumption of goods by ordinary people, a sense that this neither makes us happy or really better off. Like many people, I am somewhat cynical about this almost mindless consumption, and do have doubts about what it might (of itself) really achieve. There seem to be ever more articles in which this consumption culture is being challenged, and the articles are sometimes linked to wider problems of the capitalist system (or quasi-capitalist systems might be a more accurate description).

As another example of consumption, once again we can return back in time to twenty years ago. At that point in time, for example, the Internet was relatively new, and only later emerged into ordinary life - alongside a burst in consumption. As a blogger, I inevitably see great value in the Internet - I see it as a great tool of freedom of speech, and would not like to see a world without it. The trouble is that, in order to see this development I have to consume huge amounts of resources individually, and many other people and organisations must consume resources to create the necessary infrastructure. All of this represents economic development and growth.

Once again, in my own consumption, I can point to what appears to be a 'worthy' reason for why this consumption can be justified. What if there is no such 'worthy' justification? We might take for example the endless cycles of consumption that are associated with home redecoration, or the purchase of (the much used example of) a plasma television. Surely there is no 'worthy' way to justify such consumption?

It is very easy to sympathise with a view that relentless economic growth driven by consumption is somehow unacceptable. However, there appears to be a curious 'moralism' that frames the arguments about consumption.

Astute readers may, at this point, see that in some respects I may be setting up a straw man. I am starting to try to link consumption with a notion of worthiness. However, in linking the examples of consumption here to worthiness, I am hopefully illustrating a point. The point is that it is actually very difficult to regulate/control what is acceptable consumption. For example, a person may travel to far away places and offer the justification that they are learning about other cultures and people. That such an activity consumes massive resources might be considered acceptable by the person who undertakes such travel. On the other hand, another person might claim that this is an unacceptable use of resource.

We can see this kind of measure of 'worthiness' of consumption in the example of 4x4 cars, which have become a symbol of relentless consumption and environmental harm. Amongst some people, such consumption leads to the attribution of social pariah status for the consumers. The problem is that, with the exception of a small minority, most of those who heap such a status on others will themselves be involved in some kind of 'unnecessary' consumption. Even amongst the minority who do significantly restrict their consumption, they will often be using the resources and enjoying many of the benefits that are resultant from the system of consumption that the 4x4 represents.

The idea that consumption is somehow immoral is nothing new. We can see it in history in the sumptuary laws, as in the case of Renaissance Italy. It is a long while since I studied this history, but I recall laws such as restrictions on the use of feathers in hats. In this case the laws were dictated by the church, but who might dictate the laws to restrict consumption today? Who is going to determine which form of consumption is worthy, and which is not? How do we measure a holiday to learn about Chinese culture against the purchase of a 4x4, or redecoration of a house against a connection to the Internet? There seem to be many people who seem to think that they know the answer, but I find it difficult to see how they might make the distinction.

There is another area of consumption 'culture' which is clearly a problem. This is the encouragement of indebtedness of consumers. I do not believe that there should be restrictions on borrowing for consumption, as that is a matter for individual people to determine. For example, some people might claim that borrowing to buy a house is 'good' borrowing, whilst borrowing to buy a plasma T.V. is not. Once again, I find it difficult to determine a way in which we can determine what is 'good' and 'bad'. Is a £200,000 mortgage debt a better thing than a debt of £1500 for a plasma TV? How might we determine what is 'good' and 'bad'?

However, there is a problem in the modern system of credit. One of the first points is that there is a system in which it is very complicated to work out how much debt we are really taking on. For example, cost of credit is often presented in terms of monthly repayments, rather than absolute cost. 'Interest free' credit is promoted to such an extent that it becomes irrational not to accept the credit. However, it is not interest free, as the interest is loaded on the goods upfront, thereby disadvantaging the cash buyers. This then encourages the use of credit.

These problems can be addressed through legislation. For example, information can be better presented, with an emphasis on the actual real cost of the credit. Consumer credit law might be devised such that retailers can not charge less for credit than they themselves are paying for the cost of the money that they are lending (though this might be complicated to administer). Teaser rates, variable interest rates, and a whole host of other methods for potentially leading consumers into debts that they can not repay are also amongst the subjects that should be addressed. For example, how can a consumer know what their debt obligations might be on a variable rate of interest, when even an economist is unable to make that prediction? All of these solutions would likely see a shrinkage in consumer credit, but would not restrict the freedom of an individual to access credit. The central point is that the system should be transparent and allow people to make well informed decisions.

This does not mean that individuals will not get themselves into financial problems. As with many of my posts, the emphasis is on provision of good and clear information such that individuals are making informed decisions. The government just sets out a framework in which costs are clear and transparent. For example, as there is no such thing as 'interest free credit', it is a fraud and should be exposed as such. It is not the role of government to protect fools, but to help individuals understand what the risks are in their behaviour.

I therefore accept a role of government, but only in making the role and nature of credit transparent.

In one respect, I do not accept the role of government, and perhaps this goes to address part of the problem that Lemming raises in his question. This is the problem of government manipulation of the money supply and interest rates in order to actively encourage consumers into consumption. At its most extreme, governments have recently been guaranteeing the lending of financial institutions in order to encourage yet more consumer debt accumulation. The real problem here is that 'economic growth' has been tied too closely to debt driven consumption.

Even as I am writing, it is possible to find in many government policy statements, and policy proposals, an ambition to 'get credit flowing'. What they mean when they suggest this is that consumers should resume borrowing to buy housing, borrowing to buy cars, borrowing to buy consumer goods. They see this as a 'good thing'. At the same time, they have lowered interest rates, thereby creating disincentives for individuals to take the more responsible route of saving money to fund their purchases.

This is the point that I suspect that underlies the question that Lemming has raised. I am guessing that he is looking around at friends and family who have 'binged' on credit, paid too much for their homes, and sunk themselves in a quagmire of debt. We can all see the painful results around us, and this has been encouraged by endless inflationary policy, and manipulation of the money supply in order to keep the economy 'booming'. All the time that governments have encouraged the boom, politicians like Gordon Brown were infamously promising that the 'good times' could last.

This is the growth of economies built on the foundations of endless expansion in credit. The role of the government in this process is that, as soon as credit growth shrinks, they seek to inflate the money supply in order to encourage yet more lending to consumers by the financial institutions. I would not claim that this is only the result of individual governments, as this problem has arisen through the actions of many governments. For example, I have detailed how the Japanese government expanded money, and how this money flooded into the West through the 'Carry Trade'. This money in turn inflated house prices, and provided 'cheap' money for lending to consumers.

Whilst the government is not holding a gun to the heads of consumers to make them borrow, they have sought to structure their economies to encourage such borrowing. This has come at the cost of a culture of relentless consumption, unsustainable growth, and the abandonment of thrift and saving. The result is that there has been economic growth based upon a boom in credit derived consumption, and this was both wasteful and unsustainable. As a clear example of the waste, we can now see swathes of new housing developments being abandoned in the US, and the system was unsustainable because there would always be a limit to such credit expansion.

Whilst it would be foolish to heap all of the blame for the model of economic growth based upon credit expansion, there can be little doubt that governments have contributed significantly to the problem.

The answer to Lemming's question, and perhaps the questions of others, is that there is no basic problem in economic growth, and no real problem in a system built around consumption. The benefit of capitalism is the provision of goods and services to meet the needs and wants of individuals, and it has consistently delivered on that promise, and provided the many innovations that arise from such a system that benefit us in a myriad of ways. Whilst some point to over-consumption as a bad thing, it is hard to separate out what is good, and what is bad consumption, what is good growth, and what is bad growth. On the other hand the encouragement of consumption built upon the encouragement of debt is certainly not good for individuals, or for the wider economy. This illusion of economic growth should not be confused with economic growth built upon using savings or income for purchase of goods and services.

In other words, the underlying system works. There are broader questions about how we might sustain such economic growth in the face of finite resources, and how the marketing of goods and services might ignite a desire to consume more than we would otherwise do. However, the problem arises as to how we might restrict consumption without making moralistic judgements, and how such consumption might be restricted in a way that is fair or just. If I wish to use money for all of the consumption necessary to use the Internet, then I would feel aggrieved if someone told me that this was unacceptable. Twenty years ago, the majority of us would not have even owned a computer, but we now all accept them as items we want, and which are useful to us.

This is the reality of economic growth. We are all tied into it and, as much as we may protest otherwise, we all reap the benefits.

Note 1: I would like to apologise for not posting for a while, and am very grateful for the comments and lively debate after my last post. In particular MattinShanghai has presented an interesting post which seemed to stimulate lots of debate, and many interesting follow on comments. I am hoping to post again on the weekend, as there are several interesting points in the news, such as the G20, the struggle to sell bonds, and the issue of inflation figures. It will be tough to choose which, so I may try to do a broad brush post.

Note 2: I know that the environmental question is a major factor in the discussion above, and no doubt some people will comment to that effect. However, I have yet to see anything on the table that can realistically solve the problem of resources. With regards to man made global warming and the Kyoto protocol, I would point people to Bjorn Lomberg, as he offers an interesting perspective. However, I do not want to get into the rather muddy waters of this debate, as it will distract too far from the main point of the blog - the current economic crisis and the immediate impacts. The purpose in this post was really to put a simple (perhaps simplistic) case forward for continued economic growth. It is a huge subject in reality, and the post was always going to be limited in scope.

Note 3: Lord Sidcup - yes, the $US is still hanging on in there. It defies logic, but somehow it just withstands whatever is thrown at it, including QE. With regards to the Schiff book, I am afraid I have not read it. I was disappointed you did not like the Ascent of Money - I liked his discussion of bubbles, and I broadly agree with his Chimerica thesis, though disagree with his views on the resolution of this situation. I don't recall the economic hitman point in the book, so can not comment on that point. Like many books it has strengths and weaknesses, but for me the strengths outshone the weaknesses.

Note 4: Lemming - some good questions, and sorry I can not answer all the points.

Note 5: I have noted that there are some commentators on the blog who appear to be white supremacists. I will always publish the comments, as I follow John Stuart Mill's 'On Liberty'. However, I might mention that I do not accept/ agree with any such views, as they simply do not relate to any reality I have ever seen. I note that other commentators are addressing the points that are being made, which is good.

Note 6: Some excellent links are being placed in the comments section. As ever, these are appreciated. Some interesting posts alongside these, and it is interesting to note that there is more contemplation of war appearing. One of my ongoing worries with the current situation is that it will be easy for the situation to lead to various forms of conflict, though I do not believe that China is in any kind of position to risk a 'hot' war. I have noted ever more news of Chinese assertiveness, and note that China has just done a deal with Argentina to use the RMB for settlement of trade. The march towards the RMB as a reserve currency marches on....whilst talk of IMF SDRs as a new reserve currency seems to be keeping everyone distracted.

Monday, March 23, 2009

Economics and Power - The Loss of US Power

Regular readers will know that I avoid discussion of wider political issues with regards to the economic crisis, but events are suggesting that the two are becoming ever more closely entwined. In particular, I have long been concerned at the appearance of an aggressive nationalist agenda in China, and wrote an article expressing my concerns a long while ago:
What is very clear is that China, and the Chinese government, are actively pursuing a policy of unfair trade at home and abroad. Quite simply, they are using economics as a tool of power rather than just enrichment.
Later in the same post, I discussed an article in which it was apparent that China was intervening to prop up the $US:
'China has resorted to stealth intervention in the currency markets to amass US dollars, using indirect means to hold down the yuan and ease the pain for its struggling exporters as the global slowdown engulfs the economy...'
My comment on the news was as follows:
There are many motivations that could be given to justify this action, some of which are more forgiving than others. It might be argued by apologists for China that they are doing this to protect the value of the $trillion+ reserves of $US. However, such a move can only delay the day of reckoning for the $US, so I do not believe that this would be why the policy is being enacted. Furthermore, it is just multiplying the problem of increasing the holdings of a currency that is structurally weak, meaning that the problem that it is trying to solve would just be getting more acute. However, I agree with the article that China is using unfair means to subsidise exports.
I later added that China had already made indirect threats to destroy the $US:
On a related subject, in an article a while ago the Telegraph, it was reported that senior Chinese officials were willing to use dollar sales as a way of exerting power over the US. In short, the Chinese have the power to destroy the $US by selling the currency, and therefore have huge economic power over the US. The Chinese government later denied the policy, but those familiar with Chinese culture will know that using such methods of presenting a threat is not unusual.
You may wish to read the full post (including some of the notes in which I respond to some reader comments) before continuing with this post. It outlines some of the aggressive 'mercantilist' policy pursued by China. You may also wish to see my article on China from July of last year, in which I outlined/predicted my view of the future of the Chinese economy through the crisis (a less worrying post). The reason I am returning to the subject is that I recently dug out a report that suggests that Chinese Banking Regulators were aware over two years ago that the US was going to suffer a financial crisis:
The Xinhua News Agency has a headline news story about a recent statement by Liu Ming-kang, chairman of the China Banking Regulatory Commission, claiming that the Commission anticipated the current financial crisis over two years ago.
The report goes on to say:
“With almost everyone immersed in the excitement of (financial) innovation and large-scale liquidity for the past two or three years, the China Banking Regulatory Commission long ago predicted that the current financial crisis was soon to occur, as well as the fact that its occurrence was inevitable. We gave early warnings. In June
2006, at a symposium jointly held in Beijing by the Bank of Communications and HSBC, we warned the industry that they must guard against the liquidity risks caused by inappropriate financial innovation - derivative products in particular. At the same time, the CBRC adopted quasi-periodic adjustment and regulatory counter-measures, and warned financial institutions in the Chinese banking industry on numerous occasions of risk, demanding that they adopt strict preventative measures during this period of constant economic growth.”
That China could see the disaster coming but still continued to invest in an economy that it knew was going to suffer major trauma is most unusual. Why did they seek to prop up the $US, and why increase their reserves?

I observed some time ago that the UK suddenly, for no clear reason, changed the diplomatic status of Tibet to a status that was more to China's liking. I wrote the following:
Another indication of the state of desperation is the official UK change of status of Tibet to a status that appeases China. As one article points out, a cynical interpretation of such an action would be that the UK has 'sold' the status of Tibet - in other words this change of policy has been exchanged for a better prospect of continuing Chinese credit for the UK (possibly indirectly by ensuring that the IMF is able to fund a UK bailout).
We now have a fascinating article from the Times of India, in which they detail the many ways in which China is flexing economic muscles:
The financial crisis is proving to be a major diplomatic opportunity for China on three levels: placating a desperate United States with purchases of its treasury bonds, buy accolades from poor nations with promises of more funds and extend the international influence of the Renminbi.
The article goes on to detail the many ways in which China is using economic weight to create influence more widely, and I therefore recommend a full reading of the article. In a recent trawl through various articles I also found that China announced a new initiative in Asia to use the RMB for settlement of trading with several neighbours, in a move which suggests that the Chinese government is looking to initiate a reserve currency status for the RMB. The timing of the announcement was December 24th 2008, a time when most Western agencies would not be paying attention (sorry, could not find the original Reuters article about this, so the link is to a less reputable source). The timing of the announcement at Christmas is a good way to bury a story for Western analysts and politicians.

On top of all this, we now have a rash of news stories (e.g. here) about Chinese proposals to develop an IMF based reserve currency, and even more discussion of the growing importance of the RMB (as in the Times of India article), including as a potential reserve currency. I recently speculated on the ways in which China might utilise the economic crisis, and a forthcoming $US crisis to introduce the RMB as a replacement for the $US as the world reserve currency:
Inevitably, such a large fall/collapse in the $US will see the undermining of the status of the $US as a reserve currency. The Euro is now in a position of such instability that it will not have the potential to act as a replacement. The Japanese Yen might have some potential as a replacement, but the RMB will be better positioned as the strongest contender. In particular, the Japanese will likely act to rescue the $US during the crisis, but will fail to stem the tide, and undermine the credibility of/weaken the Yen in the process.

If China was to follow such a course, it would put itself in the position of being the major world economic power, or would do so at least in principle.
What we have been witnessing of late is a game of cat and mouse, in which China both warns the US against irresponsibility in the management of their economy, whilst at the same time offering reassuring noises about continued purchases of treasuries. Such purchases are the only serious remaining lifeline for the US government to continue with the various bailouts and stimuli. In the meantime, the US government has started quantitative easing, including the purchase of treasuries. The US looks like it is increasingly concerned that the previous and main sources of financing government debt are about to dry up.

Then we come to the crunch.

China appears to be testing its power in the disputed region of the South China Sea, in particular the area surrounding the Spratly Islands. After unarmed clashes with a US ship (probably a spy ship), the tensions are rising:

A day later, Admiral Timothy Keating, head of the U.S. Pacific Command, sounded a strong alarm, calling the incident “a troubling indicator” that China isn’t “willing to abide by acceptable standards of behavior or rules of the road.” The country’s “behavior as a responsible stakeholder has yet to be consistently demonstrated,” he told the Senate Armed Services Committee.

Some of China’s neighbors may be similarly concerned. On March 11, Xinhua News Agency reported that China dispatched a 4,450-ton fisheries patrol boat to protect its interests in the South China Sea, which include the disputed -- and potentially oil-rich -- Spratly Islands. More vessels may be added to the mission, the state-run China Daily newspaper reported.

Whilst some analysts point to a similar incident at the start of the Bush presidency, I am not convinced that this is similar. There are strong economic interests at stake in the Spratly region, and the action of the Chinese government does not appear to be comparable.

At this stage, I think that you may be guessing where this is all leading. A good starting point is to ask why China kept pouring funding into the US whilst being able to see the coming economic storm? Why did they keep lending ever more money into an increasingly precarious economy? Why are they now courting countries with the offer of the RMB as a new stable currency for exchange? What are the private demands being made of the US government for continued purchases of treasuries? We can all remember the recent Clinton visit to China, in which she offered her thanks for China's continuing purchase of treasuries....we do not know the subjects of private discussion.

Sceptics might point to the Chinese proposal for an IMF reserve currency, but it is difficult to see how this might work. The proposal might be interpreted as a smoke screen whilst they establish the RMB as the replacement for the $US as the world reserve currency?

It is possible to make a summary from the more recent news and some of the news identified in older posts. If we take the activity in aggregate, it looks very much like a plan for China to extract the maximum out of their new found economic power. They will play the US as far as they can, extract as many concessions as possible - use the power to show that they are now the country with the real influence. As soon as the US is finally in a corner and comes out to confront China, they will simply floor the $US. At that point, as I discussed in my speculative post, they will go on a shopping trip, and pick up all the technologies, all the companies that they need to take their place at the front of the world economy, and as the new economic power in the world:

With the US in shock, China can then use the remaining holdings of $US to go on a shopping spree into the US. In particular, China can offer to enter the markets with an offer of salvation - but at the cost of unopposed access to purchase the companies that might provide a leap into the high added value industries with technology or specialist skills. They will not put it this way but, in a climate of economic panic, they will be in a position of calling the shots, as the only significant player able to halt the slide. As a result of the panic, they will be able to buy even good companies at fire sale prices. As such, they will be able to use whatever $US assets they still hold to take a major leap up into added value industries.

I have worried for a long time about the rise of China, and remember an interview with a Chinese admiral (sorry, no link, it was about two years ago and I can not find the interview on the BBC website), who went 'off message' with a discourse that appeared to contradict the official line of 'peaceful rise'. I have avoided anything more than some suggestions of concern about the economics of China on this blog, but see a clear pattern in the emergence of China. It is not a friendly rise. I do not think there is any master plan in the actions, but rather opportunistic exploitation of situations that have arisen. The US has watched on as their economic power has withered. In my earlier posts, I have mentioned that the US (and the world) needed to face down China's threat to the $US, to prevent the situation deteriorating.

The situation has now deteriorated....

When I made my post speculating how China might deal with the coming $US crisis, I emphasised that the post was speculation. As I look at the pattern of China's actions over the last few years, I am concerned that I am no longer speculating but identifying a pattern. I strongly recommend that you take a look at my previous posts, which outline more detail on Chinese policy.

However, I am trying to piece together a picture from many sources of information, and it is quite possible that my interpretation is wrong. It is quite possible that China is acting without any other intention than trying to navigate through each new stage of the crisis to minimise the impact upon their own situation. This is possible, but.....

Note 1: I have several times wanted to join in the excellent debate in the comments section of my last post, but have been distracted by this post. It has been interesting to follow the elements of the debate, and a shame I have not had time to throw in my own contribution. In particular the debate started by Lord Keynes is now too involved for anything but a long answer, and I can only put so much time in....

Note 2: MattinShanghai - excellent link to Rolling Stone. A very good read, but with some caveats about the comments on regulation. The issue of Glass-Steagall Act keeps popping up as one of the problems in the crisis, and I hope to address this question at some point. Matt - did you note the nobleman analogy? Nice to see that others have come up with a similar analogy to the aristocrat which I have used.

Note 3: Lemming, yes, the US bailouts will be used (to a large extent) to support returns to overseas depositors (not the stereotypical little old ladies)...I have no reason to think that the situation is different from that in the UK. You may want to read the link above which, although it does not answer your question, sets and interesting context.

Boing: A very quick reply. One of the key points being made in this blog is that the stimuli simply can not work as they seek to replace consumer over-spending with government over-spending. Over-spending is what got us into the trouble. As for the bailouts, these are simply trying to replace overseas direct lending to banks with indirect lending from overseas investors, but directed through government. Alternatively, they print money to make up for the disappearing overseas investors. And as Lemming mentions (see above) in the comments section of the last post, much of that money is flowing straight out of the banks into the hands of overseas banks/institutions/individuals.....

Friday, March 20, 2009

More on Quantitative Easing.....

Several commentators have left some interesting links that are related to the new 'fad' of quantitative easing (printing money), and it seems that this policy is gaining ever greater traction as a policy tool. Perhaps the most interesting example is that of the proposed IMF quantitative easing (QE):
Alistair Darling and senior figures in the US Treasury have been encouraging the Fund to issue hundreds of billions of dollars worth of so-called Special Drawing Rights in the coming months as part of its campaign to prevent the recession from turning into a global depression.
The first thing to note here, is that the calls are coming from the US and UK, which are countries already following the QE policy. That the calls are coming from two of the most troubled economies only serves to illustrate their desperation. This policy proposal is simply a way to try to inflate away the underlying problems, but to do it on an international basis. As for the domestic policies of QE, there is a fundamental belief that economies can be stimulated to act in accordance with government wishes, regardless of underlying economic drivers (for those new to the blog, you may wish to read here for a discussion of the underlying economic reality).

Just to add to the curious situation, both China and Russia are considering / proposing that the IMF could replace the $US as the reserve currency by providing a clearing house, thereby creating a new de facto currency:
China and other emerging nations back Russia's call for a discussion on how to replace the dollar as the world's primary reserve currency, a senior Russian government source said on Thursday. Russia has proposed the creation of a new reserve currency, to be issued by international financial institutions, among other measures in the text of its proposals to the April G20 summit published last Monday.

Calls for a rethink of the dollar's status as world's sole benchmark currency come amid concerns about its long-term value as the U.S. Federal Reserve moved to pump more than a trillion dollars of new cash into the ailing economy late Wednesday.

[And later]

The source said the Chinese paper envisaged the International Monetary Fund's Special Drawing Rights (SDRs) being first assigned a role of a clearing currency on some transactions and then gradually becoming the main global reserve currency. "They said that the role of reserve currency should be given to SDR," the source said.

The idea of the IMF providing a world reserve currency is, to say the least, a very curious one. The IMF has a limited gold reserve, but otherwise is reliant on financing from governments of countries. The following discussion is now out of date, but sets out the status of IMF gold.
The International Monetary Fund currently holds 103m. ounces of gold, valued on its books in August 2003 at $8.1 billion (IMF, 2003a) but probably worth $38.4 bn at market prices. The IMF has no real use for this gold. Admittedly, it provides fundamental strength to the IMF’s balance sheet. However, it is a small amount compared to the IMF’s $350 bn in total resources or its $228 bn in usable currencies (IMF, 2003b). By its Articles of Agreement (IMF, 1945), particularly Articles IV and V, the IMF may receive gold from countries in settlement of obligations, but it cannot lend gold as part of its stabilisation programmes. Nor can it lease, swap or use its gold as collateral. The IMF cannot revalue its gold without selling it, and an 85% vote of the membership is required to authorise such a sale. Were the IMF to sell its stock of gold rapidly in order to generate money to meet an international financial crisis, it would depress the world price for gold and diminish the value of the gold held by countries in their reserves or offered for sale. Various efforts have been made in recent years to use some of the IMF’s gold stockpile to fund debt relief for poor countries. However, none of the efforts or plans proposed to date will generate the needed funds without collateral damage to the IMF or to the gold-producing countries. (1)
As regular readers will be aware, a fiat currency has no real value except the value that is assigned by our collective belief in the value. The question that springs to mind with an IMF reserve currency is to ask what might inspire such a belief. Whilst such belief in an IMF currency is a very curious notion, in some ways it is no more curious than our belief in the value of the $US or £GB. It just serves to highlight the absurdity and fragility of currencies which can be 'printed' without constraints.

The situation in the US is now one where money is being printed without constraint with a significant expansion of QE:
LONDON (SHARECAST) - Bond and gold markets soared but the US dollar tumbled as the US Federal Reserve chief Ben Bernanke unveiled a $300bn treasury bond buy-back plan as part of a new $1.15trn package to rejuvenate the US economy.

In a move mirroring recent actions by the Bank of England, the US central bank said it would move to buy treasury notes with maturity dates of between two to 10 years to “help improve conditions in private credit markets.”

The Fed also moved to prop up the housing market by saying it will buy $750bn of Freddie Mac and Fannie Mae issued mortgage-backed securities, on top of $500bn already pledged to the two agencies. It also doubled the agency debt it plans to buy this year from $100bn to $200bn.
One of the underlying purposes of the policy is to try to prop up the ailing house market. I can think of no better example of the bankruptcy of imagination than this policy, and no better example of a complete misunderstanding of the realities of the current situation. Bernanke is claiming that the QE policy has an end plan, but at the same time offers no actual end to the policy:

WASHINGTON (Reuters) - Federal Reserve Chairman Ben Bernanke on Friday said the Fed's buying of longer-dated U.S. Treasuries would "taper off" when the economy no longer needed help, allowing the Fed to cease its emergency support.

"The time will come when the economy will be growing, the housing market will be recovering, that support will no longer be needed. And we will of course at that point taper off that support," Bernanke told community bankers in Phoenix, Arizona.
Quite simply, I do not 'buy' the idea that there can be any end in sight to such a policy. The US government's borrowing is expanding at such a rate that there is no realistic possibility of raising the finance to cover the exploding costs. In particular China has been funding the US government and the discussion of a move away from the $US as the reserve currency is the final confirmation that the 'game' has come to an end. Once again China has issued warnings to the US:
China hopes the United States will guarantee the security of the Chinese assets and investments in the U.S., China's Foreign Ministry reiterated on Thursday

Foreign Ministry spokesman Qin Gang made the remarks in response to a question on the decision of the U.S. Federal Reserve Wednesday to spend up to 300 billion U.S. dollars to buy long-term government bonds and expand purchases of mortgage-related debt to revive the economy.
The full article is not as dramatic as the quote suggests, with Qin Gang apparently accepting the policy, but the warning still remains. Niall Ferguson in 'The Ascent of Money' called this game 'Chimerica' - the game of China funding US consumption. I made a speculative post recently on how China might finally unwind its funding of US debt, and imagine that it is likely that we will see China moving in a direction approximate to that which I have outlined. The US policy of QE, in particular the move to purchasing treasuries is preempting the end of Chimerica, in the same way the UK preempted a failed bond auction through the introduction of QE.

In the meantime China is now in a position where it is flexing its economic muscles with impunity. Their blocking of the Coca Cola purchase of a Chinese drinks company is an example of their new found power. Quite simply, the US dare not 'take on' China over such a protectionist act.

Whatever the actions of the US government and the central banks, the status of the $US as the world reserve currency was always going to be challenged, but the moves of the Fed will now simply accelerate the decline. I have continually predicted the collapse of the $US, and have been endlessly surprised at the resilience of the currency. Up to now, there has been a delusional belief that the reserve status of the $US would somehow 'save' it, regardless of the actions of the US government. A while ago I wrote a post specifically to point out the many reasons why the reserve status would not save the $US, and the policy of expanding QE to purchases of treasuries simply adds to the many reasons for why it cannot resist collapse.

As I am writing this post, I can not help but find the situation in the world economy to be ever more surreal. When I first started writing this blog, whilst being able to see the oncoming crisis, I could never have imagined that the policy makers would take actions that could take a major crisis and turn it into catastrophe. I am genuinely baffled that so many otherwise intelligent people, are undertaking the policies that they are. Several months ago, when QE policy was first being proposed for the UK, I commented on the strange way in which the Economist magazine was reporting the policy. I will quote from my post (I will not put it in block quotes as it is fairly long):

[quote starts]

This from the Economist magazine (a magazine I once had great respect for and for which I am a print subscriber):
'This is where the Fed has already been inventive: printing money to buy all manner of assets. In October it said it would buy short-term commercial paper. This week it unveiled two new schemes: a $600 billion plan to reduce mortgage rates by buying government-backed mortgage securities and the debt of America’s state-sponsored mortgage giants; and a $200 billion scheme to buy the debt backed by credit-card, car, small-business and student loans (see article). This approach could be broadened to other markets that have shut down. For instance, there is little fresh (senior) credit for firms in bankruptcy. If the government can provide that cash, it could stop the coming wave of bankruptcies from becoming one of corporate liquidations'
Apparently, printing money is now 'inventive'. Here is the same magazine discussing Zimbabwe:
'WITH prices doubling every few days, Zimbabweans now spend huge amounts of time and energy preventing their meagre cash resources from completely evaporating. Trying to catch up with galloping hyperinflation, now officially running at 2.2m per cent a year and at least four times faster in reality, the central bank has been printing ever bigger denominations. But it is outrun by galloping prices:'
It may seem odd that the local currency is still used at all. From Z$25 billion to the American dollar at the beginning of this month, the cash exchange rate had jumped threefold within a fortnight. In restaurants or shops, prices are still quoted in local currency but revised several times a day. Salaries are paid in Zimbabwean dollars, still the only legal tender. A minibus driver taking commuters into Harare every day still charges his clients in Zimbabwe dollars—but at a higher price on the evening trip home—and changes his local notes into hard currency three times a day. The local money is losing its relevance.
So apparently the printing of money is a disaster in Zimbabwe, but if Western countries do it, it is 'inventive' and to be commended.

[Quote ends]

The reason for quoting at such length is that the Economist's thinking illustrates the central delusion that Western economies are 'well managed', and that problems such as hyper-inflation are only applicable to non-Western countries. It appears to be a quite astonishing form of arrogance built upon a self-satisfied sense of superiority. The belief is that 'it can not happen here', but there really is no justification for such a belief. I can not see any difference between the policies in the UK and US and those in Zimbabwe.

However it is spun, both governments are now funding large part of their operations through printed money. Whilst the mechanisms and methods may not be so direct as those being used in Zimbabwe, there really is no fundamental difference, except that lots of people are now saying that when the UK and US print money, it is a 'good thing'. Both the UK and US also claim that the policy is temporary, but both governments had structural deficits before the crisis, both are taking no action to restrain the deficits, and both are in fact expanding the size of the deficits. Under such circumstances, it is difficult to see any point at which the policies might be reversed.

The article that I quoted regarding the Economist was titled 'Money Printing Economics - The UK and US as the New Zimbabwe?' I think that the time has arrived where the question mark in that title can now be removed.

(1) Jonathan, ES 2004, 'IMF Gold and the World Bank's Unfunded HIPC Deficit', Development Policy Review, vol. 22, no. 1, pp. 31-40

Note 1: Sorry for the lack of posts recently, but I have been distracted again by other commitments. Many thanks for the many useful links and the interesting discussions in the comments sections. I am endlessly encouraged by the intelligence of the comments, and some of the insights that are presented.

Note 2: I hope that you do not mind yet another article on QE. I am focusing on the subject as I can think of nothing else as important in the current crisis as these policies. I will move off the subject for my next article, in which I am planning to discuss some broader indicators of the state of the UK economy, and possibly also the US economy.

Note 3: I have had confirmation that I will have an article published in the Trade and Forfaiting Review, and will link to the article once it is published. The magazine specialises in trade finance, and also has some very interesting articles that are likely to be of broader interest.

Friday, March 13, 2009

The Economic Crisis - Events and more events....

I have had many useful links from readers in the comments section since my last post. All of these are greatly appreciated. I thought I would therefore turn this post to events, rather than a general theme. Having said that, there may be a theme in here in one sense, which is that the contradictions and impossibility of the current situation appears to be emerging in all kinds of directions.

Perhaps the most disturbing of all of the news, at first glance, does not relate to economics. This is the incident between the US Navy and the Chinese Navy. For those that are unaware of the incident, Chinese ships harassed a US Navy (probably) spy ship in international waters (you might wish to read here for the incident), leading the US to send armed escorts to support the ship. The reason I mention this is that one of the curiosities is that the mainstream press has completely failed (at least in the articles that I have read) to link the incident to the news of the Chinese Premier expressing concern over the value of their holdings of US debt. The two incidents are very likely linked.

Essentially, China is firing an economic warning shot, and is indicating exactly who is holding the stick over whom. I wrote of a similar incident quite a long while ago in a post on China's mercantilism, in which China indirectly threatened to flatten the $US over a trade dispute. This looks like a re-run of the threat, but with an added military dimension. Such use of power (assuming this is the case) will likely not be going down well in the US, and will reinforce the recognition that, one way or another, the US must face down the Chinese threat over the $US. At this point, we have to ask about what kind of man Obama really is, as this will be crucial to how this will play out. I have no clear idea of this, so will leave you to speculate on this question. The one thing I am certain of, is that within policy discussions in both Washington and China, this massive shift in power, and how to manage it, will later have profound effects on the world economy.

Meanwhile, in the US, it appears that the US government is ever more determined to dig the economic hole it is in ever deeper. The ink on the first 'stimulus' is barely dry and already there is emergent pressure for a further stimulus:
David Obey, the chairman of the appropriations committee, said he has instructed his staff to start drafting another stimulus proposal, though he emphasised no deadlines or timelines had been set.
This is the argument that the stimulus is never enough. It is the same argument that suggests that the Great Depression 'New Deal' was just not large enough or it would have worked. The trouble here is that, whatever the amount borrowed and spent, there is always the possibility of someone saying (when it fails) that it just was not enough.

However, the deeper concern is that, even if you were to accept the Keynesian theory, it is being misapplied. In particular, the US economy (and the UK for that matter) have just come out of the equivalent of a Keynesian stimulus which was provided by the Chinese government, oil states and Japan. Whilst the theory suggests that the government provides the stimulus, I can see no difference in the effect of the stimulus being provided by overseas money. In both cases money washes into the economy in order to stimulate high levels of 'activity'. If the government provides a stimulus it will, in any case, fund the stimulus through overseas borrowing (at least in part). What you therefore have is a stimulus on top of a stimulus. It also raises the question about the argument that more stimulus is needed. The total stimulus over the last few years amounts to $US trillions.....

Yesterday, I went to a talk provided by a senior official in the New Zealand reserve bank, and he mentioned that Keynes was not actually a Keynesian. At this point, I have to confess that I have not read the General Theory of Keynes, and am regretting that I have not had time to do so. As such, I will admit that I am not sure whether much of what is being discussed in current policy is neo-Keynesianism or the 'real thing'. However, my understanding is that the theory does not work on the basis of stimulus during the 'good times' and in the 'bad times'. Despite such details, it seems that the US government is determined to press on regardless of there being absolutely no rational economic explanation or theory for what they are doing.

As a note, the New Zealand reserve bank appears to be taking a relatively sane approach to monetary policy when compared with other central banks. Also of note is that the speaker from the reserve bank was quite taken with Niall Ferguson's 'Ascent of Money', which I would also recommend to all the readers of this blog. It is a good, though incomplete, explanation of many of the factors that have led to the current crisis.

I have also found a number of interesting articles regarding the UK being posted in the comments section. It appears that I am not alone in considering the UK to be bankrupt. The article in question was found under a headline about house prices, which is why I missed it (I am still confident in my predictions made in my first ever post on this blog so only occasionally look at articles on house price predictions):
The Numis report says: “The bankruptcy of the UK is a very real probability as the UK Government is trying to stimulate a greater debt burden in a grossly indebted economy. We believe the scale of the macro imbalances in the UK means there is no prospect of a recovery in 2009 and we expect the UK to be mired in a deep recession through all of 2010.”
The key difference here is that I believe that the UK is already bankrupt. This returns me to the subject of so many recent posts, the printing of money, and how the UK government is funding debt. I have found a fascinating article in the Spectator magazine:
In the old days, when banks lent money to people and not vice versa, UK banks would scour the globe looking for the best investments. Now, having been net sellers from 1998-2007, the British holdings of UK gilts and t-bills has surged by £30bn in the last three months – the highest since data began in 1997. No surprise, you might argue: flight to safety. But it’s funny how foreign and non-bank UK buyers seen to be able to find several better forms of safety than buying the debt of a desperate government that has just started to print money. As he so rightly says, it’s a whole new world.
Perhaps, more interesting is the chart that is provided with the article. You will see that the rest of the world are net sellers of gilts, but that the UK banks have suddenly developed a strong appetite for the gilts. It it just a coincidence that the government now has control over several UK banks, and that the same banks are now bankrolling the government? Meanwhile, the printing of money to buy gilts guarantees liquidity of the gilts..... This UK bank purchasing of gilts is very much in line with what I said would happen.....but still offers no firm proof of conspiracy.

On a similar subject, the same article that discusses the bankruptcy of the UK also has this to say about the banks and government:
“The Prime Minister and Chancellor have publicly stated that they want banks this year to lend at 2007 levels,” it said. “We think this is a crazy policy, given that too much debt was one of the prime reasons why the economy has its current problems.”
Another poster provided a link to an article from the BBC, which says the following:

The Royal Bank of Scotland is promising to pump £1.7bn worth of mortgages into the Scottish housing market over the course of the coming year.

Finance Secretary John Swinney has welcomed the move.

He claims the bank's action will help re-invigorate the property market north of the border.

Scottish Secretary Jim Murphy said the move highlighted the "positive effects" of the government's action so far to bring stability to the banking sector.
What we are seeing is exactly what you would expect to happen when a government in deep trouble gets its hands on the banking system. It appears it is using the banking system to meet government objectives, and that means massive interventions in the broader economy. An interesting point in the article above is that John Swinney really believes that 're-invigoration' of the property market is a 'good thing'. Exactly in line with my discussions at the time that the bailouts were being enacted, the government is now pushing the banks into irresponsible lending that will see even greater ongoing losses.....

The final link from a commentator that I would like to highlight is an article on the G20 summit. The article had this to say:
Lord Malloch-Brown, a Foreign Office minister involved in the preparations for next month's London summit of the G20 countries, said that meeting must produce a substantive plan to rescue the world economy or there will be "disastrous" financial consequences.
I am not sure that this may not be an overblown reaction/point of view from Mr. Malloch-Brown. However, it does illustrate the sense/perception of fragility in the current situation in government circles. Regular readers will know that I predicted a meltdown of either the £GB or $US to happen within two to three months, and we are now coming to the end of that period of time. As yet, my predicted meltdown has not happened, but it is possible to get the sense that we really are on the edge of the precipice. I have never been sure what the final trigger might be for the collapse, as it will likely be something that is as much emotional as rational. Perhaps a bad G20 might be such a trigger, but perhaps not...

In an ideal world, the meltdown would never happen. However, the world is not ideal and I can see no other final outcome. As such, I find myself on the one hand hoping that it will not happen and, on the other hand wishing it to happen before governments can make the final consequences any worse.

On a separate subject, I have noted that there has been some interesting posting on conspiracy theory, and in particular the New World Order. As such I thought that I would add my comments on the subject. Some time ago there were many links being provided in comments to various conspiracies. As such, I took a look at some of these. The first example I looked at was a video showing an Amero coin, and it turned out that it was a white supremacist behind the video. I also saw several videos, including one that ran to 3.5 hours approximately (2). I noted during the video that they were proposing that international bankers were supposed to be running the federal reserve in the US. A one minute search on Google dug up a paper on the ownership of the Fed, and it had nothing to do with international bankers.

The interesting thing about this example was that the video was full of insinuations, but lacking in any firm evidence, and that they never actually pinpointed who the owners of the Fed might actually be. I also noticed an undertone of anti-semitism throughout the video. I have since read the 'Ascent of Money' by Niall Ferguson, and interestingly this reveals that one of the discussions in the video was originally put out by the Nazi party in Germany. This is the matter of how the Rothschild family made their money in the bond market after the Battle of Waterloo. In the ascent of money, written by a very good historian, there is no 'evil' market manipulation, but in the video this is the implication.

As I have said in several posts, conspiracies do happen in the real world. Politicians, given enough space and opportunity, and down on their luck, seeking wealth, or in a difficult position, may well conspire against the public interest. The problem with these conspiracy theories that we see is that they undermine the credibility of those who seek to find the real conspiracies. As I found in my early post on the subject of the New World Order conspiracy, just having the words in the title saw an uplift in visitor numbers. In other words, duping people with these invented conspiracies is a sure way to boost reader numbers, to sell books, or more disturbingly, can be a subtle way of promoting agendas such as anti-semitism.

As such, I urge readers to be open minded to conspiracy (in particular in these difficult times) but also to be cynical and suspicious of such theories, in particular those that are based upon half fact and insinuations. You may note that, wherever possible, I have sought clarification, and have reported the clarifications in full (e.g. the BoE money printing case).

In today's post I have asked questions about UK bank purchases of gilts, but have provided a chart of activity from a reputable source. This does not mean proof, as it is also possible that the banks would have, in any case, moved into UK gilts. However, there is no obvious reason why they should do so, and therefore we might have grounds to suspect that the purchases are the result of government influence. We do not need images of shady characters in smoke filled rooms plotting world domination for such a scenario, just incompetence and desperation. A philosopher of Critical Scientific Realism (1) suggests that we should look for plausibility in theory, and incompetence and desperation are very plausible motivations. On the other hand, the genius Dr. Evils stroking their cats whilst plotting world dominion in smoke filled rooms might be seen as less plausible (I am exagerating here, but hope the point is still clear).

On that note, I will end this rather rambling post. Many thanks for the comments and the links, which are always appreciated.

(1) Doppelt, G 2005, 'Empirical Success or Explanatory Success: What Does Current Scientific Realism Need to Explain?' Philosophy of Science, vol. 72, no. 5, pp. 1076-87.

(2) I think the video was titled 'Money as Debt' but they have now blurred into one in my memory. I have linked to the videos in previous posts on the subject, and there are plenty of links to various videos in the comments against posts. If you know the title and can link to it (I think/hope that there can only be one example that is so long) please feel free to add the link.

Note 1: I have just found this article, saying that at the G20:
The Americans are thought to have arranged private meetings with Chinese officials this weekend after the Chinese premier Wen Jiabao cast doubt over the country's willingness to provide financial support for President Obama's $787bn (£560bn) stimulus plan.
Events appear to be moving, and we will see what comes of such discussions......

Note 2: A while ago I discussed a system of fixed supply of currency. I was thinking in terms of the conspiracy theory about how useful it would be to have a world currency with a fixed supply. This really would be a real New World Order....but one with only positive benefits. I could think of no good argument against it, but can not imagine that the politicians would ever cede their power for tinkering....I may post more on this in the future, but hesitate to do so on the basis that it is so unlikely to ever happen.

Note 3: The New Zealand Reserve bank official mentioned that nobody predicted this crisis, so I offered a correction for this statement. I did not mention that I predicted the crisis, but pointed to the Austrian school as an example. It seems that this story that nobody predicted the crisis simply will not go away. I also threw in my view on banking regulation, pointing out the contributions of Basel I & II in the crisis, and this point was conceded by the official. I had many other points and questions that I wanted to raise, but there were many present, so the opportunity was very limited. One of the key points I would love to have raised is the ongoing use of GDP as a measure in the economy, but felt that it could not be abbreviated into a brief question.

I should also add that there was an refreshing openness in the whole talk. Overall I was quite impressed with this aspect of the talk, and felt that I was hearing a person who genuinely sought to make sense of the situation. I have since sent an email linking to a page in the blog, but have no idea whether it will be read.

Tuesday, March 10, 2009

Bank of England - Straight Answers on Money Printing

As many readers will be aware, I have been pressing the Bank of England (BoE) on details of the Quantitative Easing (QE - Printing Money) policy that they are undertaking. As I mentioned in my posts there were several changes taking place that would allow for the BoE to directly finance government borrowing with printed money. However, I do not like conspiracy theory, and would rather seek clarification of the situation, and therefore wrote two letters to the BoE to this end. I now have had a response from the BoE.

I will let you make your judgement on the responses overall. However, there are three possible interpretations of the answers as follows:
  1. I asked the wrong questions, or asked in the wrong way.
  2. The answers are clear and represent policy
  3. The answers are not telling the truth
My own view is that I believe the answers to be truthful, and they appear to be clear and seek to answer my questions. I do have a few doubts about my questions, but think that they were well enough phrased to have some confidence. The questions and letter follow, with the answers from the BoE in blue text.

In the letter written by the Governor, he mentions a figure of £150 billion being available for the purchase of assets. Can you clarify whether this figure is an additional facility over and above the £50 billion that was previously available in the APF? In other words, can you confirm that this £150 billion is all central bank created money?

This is not an additional sum - the MPC has now been authorised to use the APF to purchase eligible assets financed by central bank money up to a maximum of £150bn. The issuance of Treasury Bills for the purchase of assets will cease and funding will be through the creation of central bank money. Up to Friday 6th March, the sum of commercial paper purchased through the issuance of TBills, less redemptions valued at initial purchase price, was £985mn. Any purchases from Friday 6 March would be purchased using central bank money.
Can you give a projected split / proportion of which type of assets will be purchased in the period March-May, and the period June-August 2009? Please give totals or ranges under consideration, and any projected figures that you are using as the most likely scenario?
At last Thursday's meeting the MPC decided to undertake a programme of asset purchases worth £75bn. The Committee recognised that it might take up to 3 months to carry out this programme of purchases, so it is only possible to talk in terms of March-May. Over that period the MPC anticipate that the majority of the purchases by value will be gilts, with the remainder purchases of private assets. The first gilt purchase operation will be held on Wednesday 11 March. The total size of that operation will be £2bn. Subsequent auctions will normally take place every Monday and Wednesday (to be clear, next week there will be just one operation, on Wednesday). The Bank will announce on its wire service pages each Thursday the size of gilt operations to be held the following week. There is more information in the Market Notice published 5 March 2009:
Can you give a clear description of how the split/proportion of assets to be purchased under QE has been determined?

The Governor stated in his letter to the Chancellor dated 17 February 2009, that in recognition of the importance of supporting the flow of corporate credit, up to £50bn of the £150bn total should be used to purchase private sector assets. The Bank currently accepts commercial paper issued by UK corporates, both at issuance and in the secondary market and is consulting on proprosals to purchase: Corporate Bonds, paper issued under the Government's Credit Guranatee Scheme, syndicated loans and asset backed securities with viable securitisation structures. It will be up to the Bank executive to decide what mix to buy, and how much, up to the £50bn authorised. The Bank will not necessarily use all of the full amount. Purchases of commercial paper are very much supply driven, hence the Committee's acknowledgement that in order to meet their objective of £75bn worth of purchases, the majority by value over the next three months will be of gilts.
Can you confirm that, under no circumstances, will the BoE be making direct purchases from the DMO of gilts? This question includes a request for confirmation that you will not be using a proxy to act on your behalf in DMO auctions, or a proxy used for direct purchases.

The Bank of England will not make direct purchases from the DMO, nor will it use a proxy to purchase assets from the DMO on the Bank's behalf.
Can you confirm that there will be no use of the provision of the Bank of England Act of 1998 15.2 (a) and (b) as a reason for non-disclosure of any purchases made through the APF, or any other provisions of the act? In other words, will there be full disclosure of what has been purchased, how it was purchased, and in what amount? I note that the MPC has no obligations to report this information, and the readers of Cynicus Economicus would therefore be reassured by a formal statement committing to such a policy.

The Bank intends to operate in an open and transparent manner. As indicated in the Market Notice of 5 March 2009, the Bank will announce on its wire services pages each Thursday the size of auctions to be held the following week and the stocks to be purchased. The results of the competitive auction will be anounced on the Bank's wire services pages as soon as possible after their end. The Bank will publish, for each stock offered, the amount purchased, in terms of total proceeds; the total size of offers received; the weighted average price; the highest accepted price; and the lowest accepted price. The Bank will publish each Friday at 10am the total amount of gilts purchased in these operations that week, in terms of the total proceeds; and the sum of gilts purchased, less maturities, to date.
And as indicated in the Governor's letter to the Chancellor dated 17 February 2009, the Bank will continue to operate the APF in an open and transparent manner, including publishing a quarterly report of the transactions undertaken, and where appropriate, information on specific transactions and operations. The amount of commercial paper purchased is already reported at 10am each Friday. To aid transparency, purchases financed by central bank money will be identified separately from earlier purchases using TBills. I hope that satisifies your concerns in this regard.

I am still not of the view that the policy is as transparent as it should be, but am largely satisfied with these answers (comments welcomed). From the above it is still possible, as I highlighted in other posts, for secondary purchase of gilts by the BoE to be used to stimulate the purchase of new issues gilts at DMO auctions. However, from their answer, they appear to be in a position where they will not take a role in this process over and above what is stated.

The alternative method for the BoE purchases to drive purchases of new issues of debt is through an indirect method. This method is for a government entity (e.g. the Treasury) to ask for a bank to sell their holdings of gilts to the BoE and then replace these with purchase of new gilts. Under normal circumstances this would be an improbable scenario, but now that the government has significant influence/power over certain banks, it becomes possible. However, having said all of this, it can only be speculation at this stage.

In the end we are left with what appears to be a non-conspiracy (at least on the part of the BoE), and speculation about other means by which the same outcome might be achieved. None of this conclusively proves that nothing is happening, but I am inclined to believe that the BoE is taking no greater role than they discuss.

In the event that the Treasury, for example, is asking a bank/several banks to use the method of recirculation of gilts that I have described, I am finding it difficult to find a way that might confirm or disconfirm such a thesis. Such a scheme might be enacted with a 'nod and wink' with very few ways of finding out what was being undertaken. The best hope, if such a scheme is being enacted, is a 'whistle blower' leaking what is going on. Such a person might be inclined to whistle blow resulting from a sense that what was being undertaken was wrong. Another possibility is that an 'insider' in the bond market might see unusual patterns of trading. This is far beyond any understanding of the market that I have, as my knowledge is very limited.

I still hold with my argument that, without some form of money printing, it is increasingly difficult to believe that the ongoing and escalating borrowing of the government might be financed out of ordinary bond sales. With governments all over the world competing for finance, and the dire warnings about the UK economy (e.g. the IMF), it is difficult to see who might want to purchase gilts. As such, I remain suspicious (to say the least) but am left with few avenues of further inquiry. Quite simply, I am left with speculation.

I will try to keep an eye on the situation, and perhaps a new approach might occur to me in the future. In the meantime, I can offer no 'smoking gun', no evidence, and nothing that should sway you to a conclusive view on the issue. For the conspiracy theorists out there, I am sorry that I can find no evidence of a conspiracy, but my aim in this blog is not sensationalism, but my best understanding of the situation.

Note 1: Thanks to the BoE for taking the time to reply to my questions.

Note 2: A heated debate on the last post.

Lemming, ended with a very tough question, which is to ask how the BBC fits with the view of minimal government involvement. This is tough because, like many, I have a curious affection for the BBC, and believe that many people share this affection. I am not 'offended' by the BBC. There are a set of principles that suggest that it is an unnecessary government intervention meeting a widespread desire for the retention of the service. Similar might be said of other services....

I will confess that, in this case, I find myself trying to square a circle. I mentioned in my post that each case intervention by government should be taken on its relative merits as to whether government should be involved, or to what degree. Curiously this is one of those questions I have debated with myself, and to which I have no satisfactory answer- but where I should be able to provide a satisfactory answer. Perhaps in this one case I am being inconsistent, or perhaps I have simply not found a way to determine the arguments either way. I am sorry that in this case, I can not give a satisfactory response, as I simply seem to be bereft of reasoned argument. Apologies.

Monday, March 9, 2009

The UK and the Silent Bank Run

There is nothing so dramatic as a line of people lined up outside a bank, hopeful of retrieving their money whilst there is still money left. It makes a good picture for the papers. What of the silent bank run? This is where there are no lines of people, but just a long line of electronic transactions as institutional investors remove their funds. No pictures. No drama. No headlines.

Some of the regular readers will know that I have been discussing such a bank run for a long time. I have suggested that the current financial crisis is all about overseas depositors steadily withdrawing their funds from the UK economy (it is not the underlying crisis). The pouring of money into the banking system by the government is an attempt to save the banking system, not only from catastrophic losses, but also from this steady bank run that is resultant from these withdrawals. As that money pulls out of the economy, it is no surprise that the economy comes ever closer to full collapse. It was, after all, the foundation on which the economy was built.

I have recently had a commentator point to an article in the Independent newspaper (many thanks to the anonymous poster). Whilst an occasional browser of the paper, I missed this very important article which, as the commentator points out, was tucked away in the dark corners of the finance section. However, this article should be the stuff of headlines and, in light of the importance, I will quote at some length:

A silent $1 trillion "Run on Britain" by foreign investors was revealed yesterday in the latest statistical releases from the Bank of England. The external liabilities of banks operating in the UK – that is monies held in the UK on behalf of foreign investors – fell by $1 trillion (£700bn) between the spring and the end of 2008, representing a huge loss of funds and of confidence in the City of London.

Some $597.5bn was lost to the banks in the last quarter of last year alone, after a modest positive inflow in the summer, but a massive $682.5bn haemorrhaged in the second quarter of 2008 – a record. About 15 per cent of the monies held by foreigners in the UK were withdrawn over the period, leaving about $6 trillion. This is by far the largest withdrawal of foreign funds from the UK in recent decades – about 10 times what might flow out during a "normal" quarter.

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.

The reason for the bailouts is the can be found in a comparison with the banking crisis in Chile many years ago. I read a paper some time ago on the subject, where an attempt was made by Chile to allow banks to fail, but international pressure forced a reversal of the policy (apologies, I hunted for the paper on the subject, but it is now lost in the 1000+ papers I have lying around). Added to this pressure is the internal pressure caused by politics, and the fact that many advisors to government come from the system that is being bailed out. This has driven governments to think that the banks must be saved, even at the risk of their own downfall.

This ongoing outflow of money from the UK banking system, and also from the UK economy more widely, is at the heart of the financial crisis. Whilst there are no headlines, there is no question that the nature of the problem is as severe as the Northern Rock fiasco. However, the UK government is in the position of guaranteeing this huge outflow and, one way or another, they will somehow need to find ever more money to support the outflow.

Quite simply, the government has made a commitment that it will never be able to keep. The only method will finally be to default through the printing press. As the demands from overseas deposits continues, more money will pour in to the banks from the government, and much of it will just transfer out of the country. The government was never going to have access to such an astonishing amount of resource.

It was a very long time ago that I first realised that the UK was bankrupt. As each day goes by, there are ever more stories that confirm this. It really is very simple. The UK collectively borrowed money that it could never pay back, as it simply does not have the wealth to make the repayments.

Note 1: It may be with relief that you note that this is a short post. I have several real life commitments that are pulling me away from time on the blog. I am hoping to be back to more regular and more deeply considered posts in a while.

Note 2: I have also been distracted by a book which is heavily promoted by the Austrian Economists. It is called 'Economics in One Lesson', by Henry Hazlitt. The book was published a long while ago, so there is a free online version here. It is relatively short ( I read it in about 3 hours approx.) and is one of the most outstanding works on economics that I have read (The Wealth of Nations by Adam Smith still tops my list). As such I strongly urge you to read it (in particular for a regular commentator Lord Keynes, as it covers many of the points that he has made in recent posts).

Note 3: Some replies to the comments on my last post on Quantitative Easing (QE - printing money):

Tiberius mentions that buying gilts directly through QE by the Bank of England (BoE) might 'be in direct violation of the Maastricht Treaty'. I think this is another reason for the circumspection....

Ketley highlights some of the BoE's statements to point out that much of what is going on is about confidence. My feeling is that 'playing' with confidence is a very dangerous game. As soon as the truth 'outs' then the confidence game comes to a messy end. Ketley also notes that there is a possibility of much of the media simply regurgitating press releases on QE, and this does seem to be the case. If only the press would take the time to look around, they might actually find some different perspectives.

An anonymous poster points out the damage of this policy to savings, and asks how much inflation will follow. My simple answer at this stage - I simply do not know. Once this process of money printing starts, it can create self-reinforcing feedback - and this makes it beyond prediction. Equally, there is no firm timescales for when it will kick in.

Lord Sidcup asked for M0 and M4 figures. M0 is no longer reported (interestingly went in 2006, I think), and M4 can be found here (only reports to January 2009 at the moment). For those that do not know what these are, basic definitions can be found here on Wikipedia.

An anonymous poster offered this analogy for QE, which is very good:
It's like we're collectively trying to refuel a car with four flat tyres.
If I can take the liberty, I might suggest an alteration - that it is trying to pump air into 4 flat tyres, all of which have punctures.

Paulsc expresses interest in the reply from the BoE to my letter to them seeking clarification of the policy. I have had a reply that they are putting together an answer, and am therefore awaiting a response. (see below for update)

Paul offered an interesting point with regards to the press, identifying their lack of spine over QE. I note that some commentators are dusting off their critical points of view, so there is still 'hope' for the press.

Lord Keynes: You say in your example:
The banks are hoarding the £30 that they have been receiving as interest. Also, the banks refuse to lend any new money to people, so the economy just can’t get that extra £30 to get the economy on track.
You are talking about lending for consumption. Lending for consumption = a future contraction....Also, nobody is 'hoarding' money. They are lending it to governments....the banks do not sit with piles of cash in vaults, but buy 'safe' assets according to Basel II requirements. 'Hoarding' is an emotive word for saving and investing. When money is not being consumed (whether by governments or consumers) it is used to invest in new business ventures. This is not hoarding.

You also say:
The central bank removes the extra £30 it injected. We are back to the original situation of £100 in the economy.
But who is going to buy the Gilts, and when are they going to be sold again. In a year, in two years, in five......

You later say:
Of course, printing money can be put to productive purposes. If the money was lent directly to the government and they spent it on building new factories producing manufactured goods (e.g., in a high value added industry like high tech) and these goods were bought by domestic and foreign consumers, then of course printing money can generate real growth
In this case, why not print £1 trillion? This would provide massive amounts of money to do things...but the money money would cease to have any value. Money is not a 'magic' thing. It represents a unit of exchange and (if it is not printed in this way) a store of value, and in a good monetary system also represents a contract.

Overall, I do urge you to read Economics in One Lesson. I believe that you read widely on economics, and believe that this book may have a profound impact, as it will give a different perspective to that of the economic theory that led us to this disaster, and is leading us ever deeper into crisis.

Lemming: Regards to borrowing/lending. The key here is that borrowing for consumption is problematic, not that all borrowing/lending is bad. You later mention:
Similarly, is it equally possible that a 'make work' scheme, or a money printing operation *could* produce genuine wealth?
If this were the case, then we could hand everything over to government and dig ditches for £1 million a day. There is only one way to increase wealth - to produce goods and services for which there is demand, and increasing wealth can only be achieved in an economy by producing more goods and services. The issue distribution of wealth is another matter, but the root source of wealth is output, not money.

On the other hand, having someone do 'make work' contributes nothing.....what is their output worth? If it is make work, nobody wants the output enough to pay for it....

I hope that helps.

Red: Very interesting link about the China spending spree. The article is broadly supportive of my recent speculation on the Chinese exit from Treasuries, but we will see....

Note 4: I am still hoping to take a look at US QE, but will struggle against events, as I think they are moving fast. One point of note comes from an article here:

European banks face a US dollar “funding gap” of almost $2 trillion as a result of aggressive expansion around the world and may have difficulties rolling over debts, according to a report by the Bank for International Settlements.

It seems that more and more trouble comes out of the woodwork. If everyone goes down the QE route.....what happens then? Global hyper-inflation? How do you guess at the future value in currencies with ever more 'dirty laundry' appearing. I made a bold prediction of the collapse of the $US, and still believe this is about to happen....but....will this delay it? I am not sure....

Note 5: I have finally got hold of a copy of Niall Ferguson's 'The Ascent of Money' and should be able to let you know whether it meets expectations in a day or two. So far, it is excellent.

Note 6: I have just found a reply from the BoE in my inbox, and will post on their reply shortly.