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.