Thursday, January 14, 2010

The Winds of Change

Since first starting to write on the economy I have slowly developed a picture of the world economy, and that picture has alarmed me. As I wrote recently, it is a picture in which policymakers have an illusion that they are in control, but a reality that they are not really able to predict the consequences of their own actions within a dynamic and interconnected system.

I have also long highlighted the problem of the use of GDP figures, on the basis that they do not really signal anything of value in relation to the underlying health of the economy. All the figures provide is an illusory sense of comfort, in which borrowing by governments and consumers, as if by magic, is recorded as income. A typical example can be found for the UK on the BBC news website:
The National Institute of Economic and Social Research (NIESR) predicts that the economy returned to growth, bringing an end to the recession.


NIESR said the pace of growth appears to be increasing. It estimates that there was a 0.2% increase in GDP in the three months ending in November.
The fact that the 'growth' is accompanied by massive government fiscal deficits is not apparently an issue. I sometimes feel that I am repeating myself endlessly in highlighting this problem, but the trouble is that it will not go away. GDP 'growth' is widely believed to signify that an economy is moving in the right direction, and it is believed by policymakers, economists and (of course) much of the general public. Even as governments rack up ever more unsustainable debt, analysts scrutinise every minute shift in this largely useless metric.

There are many excuses made for fiscal profligacy made on behalf of governments. There is the idea of stopping a 'downward spiral'. The argument goes like this; if we can only spend enough, then we will put money in the pockets of consumers, and they will continue to shop, and continue to pay their mortgages, and this will halt the downwards spiral. The reason for the problem, which is that (in aggregate) nations were spending more than they were earning is ignored. The solution is, in the end, founded upon an idea that it is possible to borrow and spend your way to wealth. Note, not borrow to invest, but borrow to spend.

One commentator on the blog insists that government debt is different to personal debt. For example, the suggestion is that government debt is supported by the tax base, and the size of the tax base is large enough such that, if need be, the money might be repaid. This is the argument that government might put money in consumers' pockets to save the economy now, only to take more out of their pockets in the future. This will happen, of course, once the economy returns to 'growth'. The 'growth' that is created is, of course, the 'growth' created by government borrowing and spending rather than the kind of growth that will lead to exports and a return to current account surplus.

It seems that the policymakers recognise this, as lax fiscal policy is accompanied by lax monetary policy, including printing money. This serves to debase the value of currency, and allows for the (potential) rebalancing of trade, and the erosion of the value of debts held in the devaluing currency. It is the hope that governments might borrow and then stealthily default on the debt by reduction in the value of the debt. The fiscal stimuli act to tide the economy over and the intention is that the true value of the debt will never be repaid. As the country emerges from the crisis, as exports once again pick up, all will be well as the debt is repaid in currency that is devalued and export growth will pick up the slack.

That is the theory, but no policymaker speaks of it openly.

The problem is this; the policy can only work if the providers of credit are willing to be duped. That is the essential flaw in the policy. To date, the governments following this kind of policy have gotten away with it so far, and I am thinking of the UK and US in particular.

I have talked about the steady erosion of belief that is the foundation of these kinds of policies. It is the belief that the rich world countries will always be rich - that one way or another the wealth will always be there as if by some divine right. The rich world has always been rich, and always will be. This is simply a question of belief, and has no logical or empirical foundation.

Wealth is something that is created through hard work, dynamism, creativity and investment. It is achieved by out-competing the competition. There are many ways in which this might be achieved, but nonetheless, it is the bedrock of wealth creation. It is the aggregate of each individual's contribution within the economy to the creation of value.

What wealth creation is not is borrowing to spend, or creation of money with no foundation in an increase in output of value. Both of these are illusions of wealth, although the former might allow for a sense of real wealth for a while - if the country can get away with not repaying the money. As an analogy, we might think of a person borrowing to finance going on an expensive holiday. They really gain the benefit and enjoyment of the holiday whether they do, or do not, repay the loan that funded it. The fiscal profligacy of governments is providing the benefits in the hope that the full cost will never need to be repaid.

The problem is this; governments have promised their electorates that the 'holidays' are permanent, that we might continue with the lifestyles financed by borrowed money. Even as they are making such promises, they are quietly and surely defaulting on their borrowing. As I said earlier, the whole edifice rests upon creditors being duped. They must continue to believe that being paid in devalued currency is an acceptable deal.

The illusion really is coming to an end now and this is the reason for this post. The continuation of the policy maker's game all hinges on 'belief'. That belief is now being eroded as, day by day, more and more questions are being raised about what the policymakers are doing. The expression 'sovereign default' is appearing ever more frequently, and the policy maker's economic flim-flam is starting to be being seen for what it is; a fraud. I have just been reading the World Economic Forum's (WEF) report on the risks within the global economy. The following quote is of note:
The worst case scenario of overlapping economic recessions with political instability and social turbulence, triggered by untenable fiscal deficits and unsustainable government debt burdens, might not, after all, be impossible.
In their highlighted risks section, they say the following:
In response to the financial crisis, many countries are at risk of overextending unsustainable levels of debt, which, in turn, will exert strong upwards pressures on real interest rates. In the final instance, unsustainable debt levels could lead to full-fledged sovereign debt crises.
They express particular concern for the UK and US, saying that "Governments, in the US and the United Kingdom in particular, are now faced with a set of tough choices, all with consequences for future global risks." They highlight the increasing of structural costs, such as the ageing of populations, and the absolute necessity for credible plans of how the fiscal deficits might be reduced. They point out the problems with formulating such plans; that the politicians need the courage to tell their electorates of the tough choices.

Their assessment of risk in reality hinges upon the idea that countries like the US and UK are living beyond their means. They are borrowing more than they can repay, and the only way to resolve the situation is for the countries to live more modestly (if you can excuse the metonymy). In saying this, they are replicating the argument that this blog has made from the first post.

The WEF is not alone. Many others are expressing their concerns, such as Nouriel Roubini. In a recent article in Forbes, he says the following:
The severe recession, combined with a financial crisis during 2008-09, worsened the fiscal positions of developed countries due to stimulus spending, lower tax revenues and support to the financial sector. The impact was greater in countries that had a history of structural fiscal problems, maintained loose fiscal policies and ignored fiscal reforms during the boom years. Going forward, a weak economic recovery and an aging population is likely to increase the debt burden of many advanced economies, including the U.S., Britain, Japan and several eurozone countries.
Roubini highlights the risks for countries such as the UK and Spain for sovereign default, but suggests that the reserve status of the $US will allow it to be amongst the last of the 'at risk' countries to face 'investor aversion'. I am not so sure, but believe that, if a country like the UK defaults, the initial reaction will be to flee to the 'safe haven' of the $US, before a rapid realisation that this is jumping out of the frying pan into the fire.

Roubini and the WEF are just some of the increasing number of analysts who are questioning the activities of policymakers. The voices talking of the unsustainable deficits are increasingly loud, and they will be making an impact. The nerves of investors in sovereign debt will be jangling. It is no longer just bloggers such as myself who are raising these concerns, but commentators with high profiles.

In my mind, it is just a question of timing now. When will the dominoes start to topple? It is still possible, in principle, that crisis might be averted. It is possible that the policymakers will pull back from fiscal irresponsibility. It is possible, but looks increasingly unlikely. They have promised to 'save' their economies. The big questions now are the questions of when it will start, and what will provide the push.

Note: At the start of last year, I made a prediction of crisis for April, and was proved to be completely wrong. The underlying principles I highlighted were the same as here. Why might I be right this time, when wrong before? The problem in my first discussion was that, I had simply not factored in the strength of 'belief' in countries like the UK and US. A sovereign crisis requires loss of belief in the creditworthiness of the country, and that belief has proved to be far more resilient than I imagined. It is why I have emphasised the high profile of commentators who are raising the concerns. It is more difficult to shift firmly held beliefs than I thought, but nevertheless it is possible for belief to shift. I believe that the process is now rapidly advancing.


  1. of the two trillion issued last year by the usg only 200bn was net issued, the rest was in some way or another qe'd. in britain almost the complete debt was taken on by the boe.
    qe is running out, my money is on qe2.

  2. CE, when you first made your predictions of the imminent collapse of the USD and GBP I must admit that my gut reaction was that, although I was (am) ignorant of the technicalities, it couldn't happen so soon. At the time I was, naively, actually looking forward to it, being in a bit of a rut and hoping for something to shake things up a bit! However, as an avid reader of this blog, I am now convinced that we have gone beyond the point where it is possible to recover the situation. It feels as though we are 'enjoying' the last few months of the illusion (but not really enjoying it as I think most people in their hearts know that the game is up) and that, as you say, it is just a question of when. In truth there was surely never any chance of a real recovery as the rot set in decades ago, and couldn't have been reversed even if a concerted effort had been made before the 'credit crunch' had even been heard of.

  3. In your note you say,

    "The problem is this; the policy can only work if the providers of credit are willing to be duped."

    I'd say that the problem is that the providers of credit are institutions using our money. Notably pensions and savings.

    Our wealth is being put at massive risk - again - in triple A rated vehicles which no one imagines can fail.

    Who would have predicted that the UK would default on their debts people will say, in the same whining voice that people use when they say, 'who would've thought that there would be a credit crunch'.

    Even though you and I can see the disaster unfolding before our eyes, there is nothing that we can do to protect ourselves or prevent our money from being used in a vain and futile effort to prevent the disaster from happening.

  4. I am from Russia sorry for my english.I wuld like comment post comment.

    I have proftible bussness in russia and also in the EU.However to start that bussness and other investments. I save money from my salarey.Also frends help me.

    It was always hard to get any credit from russian banks.So the only way is to make your owen saving plan and start.

    It is interesting to see how banks give cheap credit to people there in the west in service economis.Why people there have such good living standarts they buy apartemnts buy cars and spend money in bars and at the shops.However that money mostly is comeng from banks that give them that and they do not work hard to get that money.

    In Russia if you wanna have latest car and nice apartment you must work hard and have good job.If you dont have that you gonna live with your perons and go by bus.

    Credit cards it is not the think is russsia also only few people have that.

    I do not understend why people in the UK and other places like this. Must have that living standarts. They must start living according with they means.They have no oil and not much of gus.Also they not have somethink that we can not make in Russia or in China and Brazil.We can have good educated economist here also and we do not need experts form service economisy.In some cases we have to buy latest technology from them but it can be done.

    I think now days people in the service economis must learn that they must cut they living standarts and work hard for cars and apartments and start saving money for they future.

    It is clear that the system of crazy credit is not working and not gonna work there any more.

  5. I keep trying to point out that if people went our more often to drive around motorways to shooping malls to buy imported stuff they do not need with money they do no have then GDP will rise. Also if the government channels spending through several different layers of organisation with fees paid to all sorts of people, unlike the old days, this too will have the effect of increasing GDP. In the first instance however, we will have Balance of Payments problems and in the second increasing levels of waste and decreasing levels of real provision.

  6. Bit late for your earlier post mentioning Rare Earths, but here:

    China's doomed attempt to hold the world to ransom

  7. The tectonic plates move very slowly and with incredible force. Nothing happens for years until suddenly - it does! Violently.

    Economics seems to work the same. Economics is the sum of all our financial decisions, buying and selling. When enough people decide something will happen, and act accordingly, a tipping point is reached and the predicted becomes reality. It can take a lot longer to reach that tipping point than anyone imagines.

    But the underlying fundamentals ALWAYS reassert themselves eventually.

  8. The problem goes back a long way, and is a fundamental problem of an elective system. Politicians buy people's votes by promising the end to the their problems, and a shower of money they don't have to earn.

    I tried unsuccessfully to copy the link to an excellent interview with Milton Friedman back in the 1960s. Go onto youtube, search for Milton Friedman, and find a video called 'Pure Brilliance'. He explains exactly why government spending on welfare etc., and, indeed, government interference in the economy, is a rotten idea, and ultimately doomed to fail.

    Britain has suffered from the attentions of Gordon Brown, who is clearly a bigotted, vicous clown, who has never worked in the real world, and knows absolutely nothing about it. Is it any wonder the economy is heading down the drain at an accelerating rate? But he only made a difficult situation very much worse.

    I agree with you that, unless and until Western Social Democratic governments (and that includes any Conservative government that accepts the 'Post-war settlement' created by the Atlee government) realise that the party is over, and life cannot go on as it has been, the train wreck is only a matter of time.

    For anyone who wants to understand the decline of the United Kingdom, may I recommend Corelli Barnet's "The Collapse of British Power", "The Audit of War" and "The Lost Victory". He shows how the romantic notion of creating the New Jerusalem pushed by left-wing intellectuals holed Britain below the waterline.


  9. Great post Cynicus, but the tipping point is as ever impossible to discern.

    Great comment too, Anonymous from Russia. Always good to hear about the view from somewhere else.

  10. Not a question of faith, its a question of choices. People do not have choices, do they? The whole system of world economy is centered around US consuming its produce and acting as its bank. China, Japan and ME made an awful lot of money and invested their trillions in UST thinking it to be a safe investment.

    Now, they wake up to a sudden reality that US has consumed all the money it had loaned, and is making up fake money to buy more stuff.

    They can call this is bluff and walk away, in which case US goes under, but so does all their savings and so does their ultimate consumer. This would lead to not just crash of US economy but all connected economies too, and would just be catastrophic.

    The second choice they have is to extend and pretend - or at least hope that US some how starts making enough money to payback its loans and start consuming their produces once again.

    They would continue to take freshly printed paper money in such a hope. It would take some time to realize that they are just collecting paper in lieu of goods produced by them. And that day would be THE Armageddon.

  11. Not a question of faith, its a question of choices. People do not have choices, do they? The whole system of world economy is centered around US consuming its produce and acting as its bank. China, Japan and ME made an awful lot of money and invested their trillions in UST thinking it to be a safe investment.

    Now, they wake up to a sudden reality that US has consumed all the money it had loaned, and is making up fake money to buy more stuff.

    They can call this is bluff and walk away, in which case US goes under, but so does all their savings and so does their ultimate consumer. This would lead to not just crash of US economy but all connected economies too, and would just be catastrophic.

    The second choice they have is to extend and pretend - or at least hope that US some how starts making enough money to payback its loans and start consuming their produces once again.

    They would continue to take freshly printed paper money in such a hope. It would take some time to realize that they are just collecting paper in lieu of goods produced by them. And that day would be THE Armageddon.

  12. Great post, CE.

    A link for your amusement:

    Telegraph -- Sterling could collapse while our MPs are still pussyfooting around

    ''The message couldn't be clearer," said George Osborne last week. "If you find yourself on the wrong road, you take the first available exit." With these words, the shadow chancellor took his latest, tentative baby-step away from the never-never land inhabited by Britain's political classes and towards reality.

  13. You could argue the entire borrowing system of western countries is set up on the understanding that they only have to pay their debt back in currency not in value.

    Look at those buying houses. They *expect* that inflation will rot the debt and asset inflation will increase their equity. Their ability to get on the next rung of the housing ladder depends upon it.

    Nations only reflect the attitudes of their citizens.

  14. UK economy faces decade of 'painful readjustment'

    "The UK economy faces a decade of "painful readjustment" as it refocuses from debt-led consumer spending to increased exports, a study has warned.

    That is the conclusion of the latest quarterly report from the Ernst & Young Item Club economic forecasting group"

    Guess they finally started reading your blog Cynicus!


  15. An interesting article on BBC news:

  16. The more and more I watch this drama slowly unfold, the more and more I am convinced of the West's strength in dealing with it. There is a significant and often underestimated Western hegemony of practice, principles and culture in our civilisation that is imbued globally, and there are structures and alliances aplenty that reinforce that hegemony... The main thing that has been on my mind recently that reinforces these inclinations are ponderings on the role of the IMF.

    I invite any IMF knowledgable people to educate myself and others as to the role of the IMF in this crisis, and proffer their ideas as to how the IMF might mitigate in the event of a major sovereign default.

    There are rumours, stories, myths and legends around about how the IMF might be partisan in relation to special interests like big corporates & their host nations, but how true are these? How far can the IMF go in supporting defaulting nations - there are austerity conditions attached to loans usually right?

    Also, another big question, and indirectly related - why are the credit ratings agencies dilly-dallying with downgrades? I have read that they are too scared to 'pull the trigger' and downgrade UK/US... In whose interest is this? Presumably everybody's? After all, a UK/US downgrade probably would be the straw that breaks the finacial system's back...

    IMO the Western alliance is still calling all the shots, and I believe everyone is collaborating - the ratings agencies, the IMF & all the major players. The big challenge for the alliance is managing the decline humanely & civilly.

    I am convinced there will be a substantial drop in the value of stirling (not difficult to predict when Soros is openly shorting the pound), and there will be painful readjustments for the sake of the balance sheet, but I cannot see the pound or the dollar falling off a cliff, not when there is the apparent level of collaboration happening at the level I am suggesting. I just cannot see it. I have always said that something out of leftfield could tip the balance - war/lethal swineflu mutation etc etc. but anything else is just not being able to see the power and extent of the West's hegemony.

  17. The Anonymous Guy from Russia made some very fair points, I think.

    But what makes Britain a place people want to live and work are the freedoms we enjoy.

    That's why protecting those historic freedoms is just about the most important thing we can do.


You are more than welcome to comment on the posts, but please try to stay on topic....I will publish all comments, excepting spam and bad language, and my moderation of the comments is just to exclude these.

Please allow up to two days for the comment to appear.

I have had a request for an email address for the site and have created the following:


I have ommitted the @ symbol to avoid spam....

For general purposes I would suggest using the comment form, but will occasionally look at this email account. Please be clear what is for publication and what is not, though I will also not guarantee publishing of email comments, unlike the comments through the form! Thanks.