Saturday, October 22, 2011

The Wheels are Falling off....

Oh dear, oh dear. Is the the grand project about to come to a crashing end? The EU and Euro have never looked as fragile as at this moment in time. However, there is a caveat; there is still a strong determination to hold the project together. The question is whether determination is enough in the face of the conflicting interests of very differently positioned EU members and in face of the storm that is now assaulting the EU and Euro.

I will not cite any of the news on the ongoing problems, as just about all the media are talking about the same problems; the fracture between the French and German positions, the IMF's reluctance to provide further bailouts for Greece without banks taking a major 'haircut' on Greek bond holdings, the growing resentment of the 'bailees', the proposals for a true financial union.Then there are the problems of the banks that are exposed to the risks of multiple sovereign defaults.

For all of the determination of politicians to save the grand project, it seems that the prospects for the EU and Euro to crumble are increasing. Of course, the former does not create certainty on the latter. However, if the Euro does crumble, will the political drive survive the recriminations that will follow? It seems unlikely but, again, it would be unwise to underestimate the determination of those who support the grand project. The EU as an institution will fight for survival in the face of any storm, and still has support of many politicians throughout the EU.

You will note here that the questions resolve around politics rather than economics, but now the economics are driving the politics. This is, in some respects, a reversal on the foundations of the EU and Euro in which politics drove the economics.

For the moment, I would like to just speculate on the scenario that there is no final resolution (which seems likely) which satisfies the financial markets. If this is the case, the crisis will hit hard. The reason is very simple - it is not just Greece that is overextended; it is not the only country that is unable to pay back the money that has been borrowed. I have long talked of the fallacy of GDP, that it includes activity that is derived from borrowed money, and in particular includes overseas borrowing. The way that GDP is measured sees increased borrowing from overseas creating activity in the borrower's market, and this gives the illusion of 'economic growth'. At present, for example in Greece, the economy is contracting even with borrowed money creating activity in the economy, and that is a signal for the state of the other 'at risk' economies.

There are some really fundamental points to consider here. The first is to return to a theme of this blog. Countries are unable to borrow money of themselves; they can only borrow and spend money on behalf of the tax base. As such, whether people or businesses, the ultimate borrower is the taxpayer. Some economists delineate public and private debt, as if they were different. However, public debt is in the end private debt as it is taxpayers that must repay the debt, not the government. The government just serves as the legal entity that signs for the debt, and then acts as a conduit for the repayment and distribution of taxpayer debt.

When we consider the position of Greece, or any of the other 'at risk' economies, it is apparent why the crisis is taking place. There are two possible purposes of borrowing and these are 'borrowing for consumption now', and 'borrowing for investment'. For the latter, provided the investment increases productive activity, it is generally a good thing to borrow money. I say generally, as this is not always the case, and this is where it becomes rather tricky to explain the problem. For example, investment in a restaurant will result in productive activities of 'making good food' or 'making convenient food' and so forth. It appears that it is a good investment. The problem arises when the investment is based upon a mistaken assumption about the real number of potential customers and the real underlying spending power of those customers.

If many people are reliant on borrowing for 'consumption now' as a determinant of their ability to spend in the restaurant, then there is a potential problem in the future. It is actually a double-whammy. If the people are reliant on borrowing to increase their spending power to be able to afford the restaurant, there must come a point at which they can no longer borrow, as they must be progressively accumulating debt, and that means that their debt to income ratio will be moving towards a negative. As such, at some point, they must switch from borrowing to repayment. At this point, they no longer have the borrowed money to provide the spending power to go to the restaurant, but also will have less money to spend on other things that they would have been able to buy, if they were not repaying debt. This is the double-whammy.

Now, if we return to so-called government debt, and remember that this is the debt of all taxpayers, then it becomes apparent that, when governments borrow, they are increasing the spending power of each taxpayer, but at the future cost of the double-whammy. If we think of our restaurants, the investment in these appears to be an investment in productive capacity, but in reality it is investment in over-capacity in relation to the underlying size of the market. Borrowing for 'consumption now' by both individuals and government has encouraged the development of capacity with a finite life. Meanwhile, those parts of the economy that, without the borrowing, might have been sustainable, get hit by the double-whammy. Not only can the taxpayers now not afford x, they can also no longer afford y, as they are now paying for the borrowing for 'consumption now'.

If we add in the accumulation of so-called private debt, or debt to which an individual has personally consented and has a personal repayment obligation, then it is possible to see how an economy can become distorted in creating capacity that is, in the long term, unsustainable, and which distorts activity and investment into over-capacity.

Now, we need to think of an individual German worker, for example working in a car factory. Our German worker is productive and helps in creating value in assembling cars. He takes home a wage, spends some of his wages, but also saves some of those wages. There are many ways of saving money but, for simplicity, let's say that he places the money in a pension fund. Included in the portfolio of the pension's investment fund are Greek bonds. Those bonds have gone to the Greek government, which spends the borrowed money in the Greek economy. This input of money from Germany increases activity in the economy, and will allow, for example, more Greek people to have the spending power to buy a German car. This in turn encourages an increase in capacity in the German car factory where our German worker is an assembly worker.

If we think of the way the system is working, it is as follows; in aggregate, lots of German workers are lending lots of money into the Greek economy. This allows the people to consume more German goods and services. In the financial industry, they say that this creates assets for the German worker, but those assets are actually debt obligations from (in the broad) Greece. They are only assets if Greece is willing to return the value of the asset plus interest. The problem is that Greece as a whole has been borrowing for 'consumption now', and even borrowing for investment was in many cases just supporting investment which was supported by borrowed money for 'consumption now'. The financial institutions that claimed they were buying assets with our German workers' savings were in fact primarily providing money for 'consumption now' for the people of Greece. The deal with 'consumption now' borrowing is that it must be matched (and exceeded because of interest) in the future by the double-whammy of less consumption, unless there are increases in productivity.

This is not to say that all of the borrowing in Greece was for 'consumption now', but the parlous state of the Greek economy is suggestive that this was a major proportion of the usage of borrowed money.

Squarely in the middle of this, we have the banks that lent the money. On their books, they have so-called assets. These are of course, obligations for x to pay debt. My intention here is not to go into the complexities of fractional reserve banking which I will leave to one side. However, some of the 'assets' purchased are not funded by inherently speculative use of savings, but by deposits which the banks must return on demand. If a debtor fails to repay debt, then the asset is in fact a liability. If enough debtors refuse or unable to pay, the bank will have greater liabilities than assets. It is bust, and all the depositors lose. In addition, those who gave the banks money for speculation will lose money (e.g. pension funds).

Staying with the Greece and Germany example, the problem is that Greece does not accept the double-whammy, and to do so would see a massive drop in the living standards of people in Greece. They simply do not want to pay back the debt to Germany. In some cases, in the case of 'private debt', there is simply nothing left to pay the debt back with; some of the sectors of the economy supported with borrowing for 'consumption now' are collapsing. The overcapacity supported by 'consumption now' is disappearing and with it 'assets' are disappearing. In the meantime, in Germany, for example where our car assembly worker works, over-capacity starts appearing as demand for German cars in Greece declines. Whilst it is possible that this capacity might be directed to other markets, what happens when other markets (e.g. Spain) see similar declines? How much over-capacity is there in Germany?

The really massive problem boils down to this. Money has been lent into supporting 'consumption now', and this money was lent without ever really considering how the consumption now might be paid back. In part, this was down to the flattery of GDP figures, but also due to banking regulations that pronounced that certain types of debt were safe. The problem is that there is nothing left to recover when debt is used for 'consumption now'. For example, the cars purchased with borrowed money are literally consumed over time (I use a physical entity such as a car for simplicity, but I hope that you can see the same point with services). Unless the Greeks now produce things of equivalent value to repay the Germans, massively reducing their own consumption in the process, the loss must take place. Unless of course, the Greek economy has an overnight miracle of productivity growth....

Then there are the savings of the Germans. If Greece does not meet its obligations, then the savings that have been poured into so-called Greek 'assets' will disappear. Even if governments borrow (from where?) to support the banks/other countries, the problem is that they are borrowing on behalf of tax-payers in order to protect those same tax-payers from losing money on their own savings. They do not lose their savings now, but they still have to effectively repurchase the same savings through the tax system. It comes back to the idea that governments can borrow on their own account. They cannot.

At this stage, I would like you to take a pause for thought. I would like you to think this through for yourself, as it puts a whole new context around the pantomime taking place amongst the governments of Europe. The tax-payers of Europe are borrowing money to bail out the losses on their own savings? Every Euro used by government to fill the hole of losses creates an exact equivalent of a Euro + interest obligation from tax payers on the borrowing. It is, of course, an absurdity. As there is nothing but tax-payers to repay the debt, it can only be a redistribution of the losses. And whoever lends the money to fill the hole from the bad debt, will want interest for their lending. Tax-payers bailing out themselves?  Or, here is a thought, is it that the taxpayer money is being used to save the banks?

I am, of course, simplifying overall. I have just focused on Greece and Germany, and excluded all the other actors throughout much of the discussion. However, when considering the big picture, we can see similar networks of relationships between individuals, economies, banks, governments etc. In the end, it is all about borrowing for 'consumption now', without the ability of the over-consumers to repay their borrowing. Meanwhile governments claim that they can save the day, but they have absolutely no resources of their own to use to save the day. They only have their tax-base to fall back upon, so that they are using tax-payer money to save the same tax-payers (or banks) from financial loss. The interesting part of all of this is that, if you listen to the news, you would think that it is governments, not tax-payers who are borrowing the money to 'save the EU' or 'save the Euro', or save the 'at risk' countries. In summary, the whole pantomime is simply madness.


  1. Yes, taxpayer money is being used to support the banks.

    And the reason matters have descended to the low farce we currently see is that there is no connection between the taxpayer and the rulers of the EU - we have taxation without representation. Our masters are like a tramp trying to buy a mansion, and not many people would put their hand in their pockest to fund that one.

    Having said that, sadly we see that, even if there were a tenuous connection, as between the UK voter and Gordon Brown, the majority of people in the UK (and preumably Greece!) still believe that a viable solution to the problem is for the government to increase spending of its "own" money. Brown only failed -only! - because he was a dysfunctional cretin, not because the voter objected to his economic policies.

    Incidentally, I have long believed Brown's greatest achievement was to promote GDP to the status of sole economic indicator to the exclusion of all others.

    Of course, this was because that his own looney policies increased GDP, whereas the old fashioned ones told a rather different story...

  2. Seemingly the FED are going to implement Nominal GDP Targetting, here is a link to a video by the economist pushing this:

  3. Thank you for once again clarifying what is going on by cutting through the fog of obfuscation spread by most reporting and comment. As ususal your analysis confirms my intuitive 'common sense' feeling about what is happening. Your description of 'governments' borrowing money to bail out taxpayers reminds me all too clearly of the fantasy of a perpetual motion machine...

  4. I always look forward to your articles; a much-needed oasis nestled inside a sandstorm of increasing incredulity!

    Now, and you may have to excuse my naivety here, there is talk of bolstering up the EFSF bailout fund up to $2-£3 trillion euros (the ultimate 'sticking plaster' to appease the markets and thus bringing about a 'happy ever after').

    What I don't understand is, where this money comes from. I did assume this money would need to be backed up with real assets or from Johnny Taxpayer. However, am I right in thinking it will be printed (as is the vogue)?

    Given the US and UK have also printed money, I suppose the EU doing the same keeps everything 'in sync' - and gives the perception to taxpayers in these countries that they still have x dollars/pounds/euros in their pockets; yet (of course) those same currencies are worth less and less all the time as the dilutive effect of printing more kicks in.

    If I imagine walking around the High Street and imagine everything going up by 50% - which I believe will happen during the next few short years - I think that, as long as it happens gradually, the populations won't 'overly' complain. They still have x dollars/pounds/euros in their pocket after all!

    That's the final masterplan of our leaders as it's recognised that the party is over and we must all, by hook or by crook, live within our means. But can our leaders pull it off and can the mega-wealthy keep their wealth? That's the battleground.

    A very simple view, but in my eyes, a simple distillation of all that's going on.


  5. Check out this recent interview with hedge fund legend Ray Dalio.

  6. There is the free market, and there is also the idea that growth is perpetual and that growth swallows debts without having to really repay them. People who believe in the former invariably believe in the latter.

    The latter, almost religious, belief allows people to borrow (and lend) money with impunity. It also allows governments to "take decisive action" and "do whatever it takes", by borrowing and printing on behalf of their tax payers using something akin to the Martingale betting system, because everyone *knows* that it will eventually kick off growth and we can all put the debts behind us like a bad dream. Not believing this makes you some sort of crank.

    Does an irrational faith in perpetual growth influence people's economic decisions and therefore distort the operation of the free market? Why is a religious faith in perpetual growth inextricably linked to the fairly plausible idea of the free market? Is it because without growth, financial industries like savings, pensions and investments fall apart? Is it because debt based issuance of money with interest can only work with perpetual growth? Is the tail wagging the dog?

  7. As always, you put the matter much more clearly than I could ever pretend to do; thank you for this essay.

    I believe the key to everything is stuff. If you make stuff and are able to sell it for a profit at a price buyers are willing to pay you set-off a merry spiral of wealth-creation. You make a profit, the wholesaler makes a profit, the retailer makes a profit and all because Mr Ordinary is willing to hand over his money to buy your stuff from a shop.

    You receive your profit from the wholesaler and spend (some of) it, the wholesaler receives his profit from the retailer and spends (some of) it, the retailer receives his profit from Mr Ordinary and spends (some of) it. Everything in the chain is sustainable because real stuff lies behind the whole series of actions and the final payment is made by Mr Ordinary out of money he has earned.

    You can add-in many more links to the chain such a transportation and packaging or take out the shop by selling on the internet, but the principle remains - if there is a customer willing to pay a price that delivers a profit to everyone further up the chain the whole system is sustainable.

    The real hitch is credit.

    Credit allows increased current economic activity and the illusion of increased current wealth-creation when, in substance, it is increased current economic activity funded by the hope of future wealth-creation. When the future comes the new wealth, or part of it, has already been spent and cannot be spent again.

    This is a particular problem for governments who build whole departments of non-jobsworths doing thing that don't need to be done but appear affordable because of the illusion of perpetually increased tax yields from credit-based economic activity.

    It can't go on.


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