Economic Crisis - The Elements of Collapse are all in Place

Note Added Later: For US readers, there is a (slightly) more in depth discussion of the US bank nationalisations at the end. However, many of the points are the same as in my previous post on the UK...similar solutions, similar problems.

It seems that the US government is indeed going to follow the lead of the UK on bank nationalisation. In more news The Telegraph reports that the total (so far) committed to the bailout is in excess of £2 trillion (note for US readers, that is £GB!) if EU countries, the US and UK are added together. This is just the headline figure, and does not include all of the other measures that have been taken to increase liquidity. Meanwhile the UK stock market commenced a rally, only for the US stock market to pull the rally back down to earth. As I mentioned in my last (or a recent) post economic reality would bite into the false optimism. The Telegraph gives the reason for the fall as a slew of bad news from various companies, indicating that reality is just not playing to the script that governments would like:

US investors ignored comments from Mr Bush that the equity purchases were an “essential, short-term” measure and exhortations from Mr Paulson urging the banks receiving capital injections to use the funds to spur economic growth. Instead they focused on gloomy corporate news from soft drink group Pepico and software company Microsoft.

The reality is that economies are contracting, and no government action is able to stop the process. This from the Telegraph:

'World trade has already stalled. The Baltic Dry Index measuring freight rates for shipping has crashed by 82pc since May, touching a five-year low yesterday. Container vessels are leaving Asian ports with 20pc spare capacity. "We're heading into a global recession," said Simon Johnson, the IMF's former chief economist.'

No doubt, the tiny fall in the Libor (London Interbank Offered Rate - the interest rate at which banks lend to each other) will be taken as a positive sign, and will be hailed as evidence that the bank nationalisation is working. It is early days yet, but the tiny fall is a very poor result considering the dramatic action of nationalising major banks, and the cost of the bailout. Furthermore, even if the banks do start lending to one another, it will not stop the ongoing financial problems of the banks, which will see considerable worsening of their situation in the coming months (see previous posts). Once again, any growth in optimism will be short lived. I have said this many times, and it seems that others are nervous of the state of the banks, even after the bailout. For example the UK Treasury Select Committee Chairman:

'John McFall called on the rescued banks to provide much more detail of their exposure to derivatives and other complex assets, many of which have been plunging in value. He said: “It's a minefield we are tiptoeing through. That £37billion might not be enough.” '

However, there are those that think the financial crisis has come to an end:

If the history of financial crises is any guide, the violent credit shock of 2007-2008 has largely run its course. The sovereign states of the US, Britain, France, Germany, Italy, Spain, and Holland have broad enough shoulders to carry their load of fresh liabilities – even if Iceland does not.

This is a fascinating point of view, because the article goes on to say that phase 2 will see the damage to the rest of the economy. The delusion in such a view, I hope, is obvious. As the consumers default on personal credit, mortgages, and commercial borrowers go bankrupt, are the banks somehow going to be insulated? They have massive exposure to the state of the real economy (what else is there?) and, in many cases, have security in assets whose value is falling. The state of finance is linked to the rest of the economy and is not some island of activity. An end to the financial crisis? I think not - at best, a pause.

Meanwhile, the UK government finances are looking ever more threadbare, and the spending deluge into the public sector is being called to a halt. There are already discussions in government of lack of money being unavailable to follow through initiatives, as is detailed in the Times.

'A confidential presentation made to officials by Suma Chakrabarti, Permanent Secretary at the Ministry of Justice, detailed the savings required from the department 18 months after it was set up. They include the loss of 9,891 jobs in the prison, probation and court services – more than a tenth of the workforce – with one in three coming through redundancies. These cuts, along with a freeze on new recruits or the use of agency staff, could lead to the closure of up to 100 courts.'

No doubt, these kind of discussions are taking place within the US government as tax receipts fall, and costs rise. As I originally predicted in 'A Funny View of Wealth', as the government finances decline, there will be tough choices, and the shrinking back of the state sector will further ratchet down an already shrinking economy. The continued bailout of the financial system is likely to make borrowing for the government ever more difficult, and the crisis in government finances is just months away (I believe in three months time).

My guess is that, in the next couple of weeks, there will be a roller coaster ride of optimism, followed by pessimism, with stock markets continuing to swing in different directions according to changes in sentiment. As such, I do not think that too much attention should be paid to each swing, as it is not a reflection of any underlying economic reality, but dictated by emotional reactions to the situation.

Meanwhile, in the UK, an economist had this to say about the UK house market:

'David Miles, Visiting Professor of Finance at Imperial College Business School in London, said that the property market should stabilise once house prices lost 20 per cent of their value from the peak of the market last summer, which would translate as a further decline between 5-10 per cent.'

One wonders on what basis he has made such a calculation. Exactly what factors are going to halt the slide? Perhaps he knows some positive news that everyone else does not know about. I read another similar prediction from one of the banks, but have not been able to find the article. I have to ask, why are these people still taken seriously? I have even found an article that is suggesting that stocks are cheap at the moment, such that they are currently a good buy.

So now to pull all of these stories together. The first point to make is that, as I previously suggested, the first nationalisation is almost certainly just the start of the drain on government finances. The governments in the UK and US, as well as the rest of Europe, will need to be digging into their pockets on an ongoing basis in the coming months, including providing ever more money to support the nationalised banks. The cost of these bailouts is already simply astounding, and yet they so far have done very little to improve the situation, again exactly in line with what I predicted. Also, as expected, the governments are now starting to cut back, and the final downward levers in the economy are starting to come into play. In short, all of the elements of economic disaster that I predicted in a 'Funny View of Wealth' are now finally enacted. What I did not (and could not) predict were the actions of governments when the crisis finally came. Regular readers will be aware of my very negative views to all that has been done so far.

Now, at this early stage, in particular with the actuality of the bank bailout in the US mired in ineptitude and confusion, the full results of the bailout are not apparent. No doubt, when the US bailout eventually fails, it will be suggested that the problem was 'implementation' rather than the reality that it was never going to work. However, the effects of the bailout can be predicted in one respect, even at this early and confused stage. They will not work.

The real question is how long governments will continue to pour money into the financial system before the reality of failure sinks in? Or perhaps, it will be the creditors to the West who will call a halt by freezing lending? I am not sure which will come first, abandoning the effort or a forced halt. If I were a betting man, I would put my money on the latter.

I will continue to watch the unfolding of events, but may not post as often. As I have mentioned there may be swings of sentiment, and these are not going to be linked to underlying causation or changes in the situation. If I see something that does reveal something new, or anything which profoundly impacts on the situation, I will of course return to my keyboard. In addition, I have had some questions, and would like to answer these, if possible and time allows (apologies in advance if I can not manage this). For new visitors, I suggest a look at the links at the top left of the blog, which I hope will be more informative than just following a series of events. They will (I hope) give context and understanding of what is happening.

Note:

I have just been taking a look at the New York Times, which I do fairly regularly to get fresh perspectives from US (though it is on my secondary reading list). What I always seem to find is that the UK and US are running down parallel tracks, give or take some finer details, and small matters of timing. For example, today there is an article on the US bailout (no surprise there), an article on falling consumer spending, and even an article on a non-profit hospital unable to borrow (not quite public sector but....), and so forth.

As for the bailout, the major news, the NYT reports the potential cost of the bailout is put in stark terms as follows:

'All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks. The latest show of government firepower is an abrupt about-face for Mr. Paulson, who just days earlier was discouraging the idea of capital injections for banks.'

The real costs will only become apparent in the next few months, as if these numbers are not enough cause for concern. Existing debt will likely prove far more toxic than imagined. The additional liabilities over the $700 bn spend are for guarantees for new debt. I have already detailed how any encouragement to lend from government is dangerous in a previous post, so the devil will be in the detail here, and that initial detail looks alarming:

'How would the government’s stake affect other preferred shareholders? Would the Treasury Department demand some control over management in return for the capital? How would the warrants work? [...] He [Bernanke] told the bankers that the session need not be combative, since both the banks and the broader economy stood to benefit from the program. Without such measures, he added, the situation of even healthy banks could deteriorate.'

In other words, it appears that the idea is that the banks must lend in the interests of the wider economy or 'wider good' (see my previous post for a discussion of why this is wrong headed). Once again, the parallel with the UK is clear.

An interesting point of difference between the UK and US appears to be that there is a more negative sentiment overall about the nationalisation of the banks, with even Paulson appearing to be (possibly disingenuously) apologetic. By contrast, in the UK, there seems to be more bovine acceptance of the situation, and the politicians pushing through the bailout appear to be enjoying their own sense of importance.

I will step out of more solid economics and speculate a moment. In this contrasting perspective, it is possible to discern an additional reason why the US might come out of this faster than the UK - a difference in outlook. In the UK there is a more firm belief that the government can 'fix' the problems, and that solution lies in the hands of government. In the US, there is more cynicism about the role of government and this is seen in the strong sense of unease about the bailouts. It may be that the US will turn away from magic wand solutions far faster than the UK. However, this is determined in the end by fickly politicians and public mood, as much as by circumstance.

On that note I will leave the post, and hope that the US readers will have some food for thought to the use of their tax dollars - bailing out banks and to be put to use in lending in the 'wider interest' of the economy. Can you imagine a more sure fire way to see money poorly invested?

Bank Nationalisation - A Continuation of the Debt Economy Delusions

The dust is starting to settle on the first tranche of bank nationalisations, so I thought it might be worth considering what this will mean. First of all a quote from the Telegraph article (link above).

'Mr Brown was said to be "genuinely shocked" when he was told how much cash was needed to recapitalise RBS, which was ordered to accept up to £20 billion of investment, making the Government the majority shareholder.'

This is an interesting point, as it is an indication of how severe the problems are. However, my suspicion is that this is about the problems at this current stage of the crisis, not the problems that are going to emerge as the economy continues to contract. There is already talk of needing more money for the bailouts and, as more and more consumer credit, commercial debt and mortgage debt goes bad, there will be ever more need for additional financing. In other words, this is only the start.

The next quote from the same article is also very revealing:

'Banks will effectively be state-run, with Government-appointed board members put in place to ensure it once again begins lending to businesses and individual customers. Together with Northern Rock and Bradford & Bingley, the move will mean the Government effectively has four of the country's biggest lenders under its control.'

This really goes to the heart of the matter, as it is here that one of the greatest dangers lies. The question here is 'lend to whom, under what circumstances?' Aside from the long term risk of political decisions on lending (using the banks money to lend to failing 'key' industries etc.), there are more fundamental questions.

It is not entirely clear from anything that has been announced exactly what the direction of this lending might be. As such, I need to speculate on some examples. Let's start with lending into the individual consumer mortgage market. If this is the direction, then the lending will be directed at a market where the security for the loan is declining in value. In this situation, unless there is a considerable deposit required, the banks will be lending into a very high risk market. If it is consumer credit, then it is an attempt to prop up the service sector, and in doing so prolong the credit driven economy. Furthermore, if this is the intention, it is again lending into an increasingly risky market, as unemployment is now increasing very quickly, and that will mean ever more consumer debt defaults. If the lending is to businesses, once again, the risks are very significant, as the economy is entering into recession and that means an increase in commercial failures. Finally, if it aimed at inter-bank lending, it should not be forgotten that the reason for banks lending to one another is because the banks are worried that other banks are insolvent. The scale of these problems have already been revealed in the nationalisations.

Now the key question. Will this new lending be used in any significant way to build new productive assets, such as new manufacturing plants, or investment in new technologies and equipment for manufacturers? In other words, will the money be lent into wealth creation investments, or will it be used as a continuation of the debt money-go-round? Why is it that I suspect that very small percentages will be used for real wealth creation?

In short, banks are not lending not only because of hoarding of capital, but also due to the fact that there are very high risks in most forms of lending at this time. In other words, the government will be forcing the banks into behaviour which will, in the long term, just create more problems. I may be wrong about the lending into real wealth creation, but I do not think that this will be the case. The underlying idea in these nationalisations is to restore 'confidence', and by confidence the government really means to prop up the service based economy with new lines of credit.

The government is talking about re-privatisation in about five years time, and suggesting that the nationalisations will not cost the taxpayer money in the long term. The idea that the government will be able to gain any return on the investment, in light of what I have discussed, is very remote indeed. Instead, as the finance of the nationalised banks continue to decline in parallel with the economy, the government will find itself having to provide more and more capital injections to keep the banks afloat. This will be never ending, as the risky lending that is the condition of the nationalisation will just produce ever more toxic debt.

As if this were not bad enough, these nationalisations are creating a massive distortion in the banking market. In a recent article, Barclays (not one of the nationalised banks) has suggested that the nationalised banks will be hobbled by state intervention. This could not be more wrong. There is a precedent for what happens when there is an implicit state guarantee for a financial institution, and that is the example of Fannie Mae and Freddie Mac. The result of the implicit state guarantee meant that these institutions could raise money more cheaply than rivals, leading to their domination of the US mortgage market. This in turn left only high risk lending markets, untouched by the two mortgage giants (except that they bought into the risk through the 'backdoor'), for their rivals and is one of the explanations for the growth in sub-prime. In the case of bank nationalisation, the guarantee is not just implicit, but is explicit. What kind of distortions will emerge from this?

If both individuals and companies see the nationalised banks as a safer bet, it may well be that there will be a shift in deposits to these institutions, creating a chain reaction of crisis in institution that might otherwise have been healthy. It is possible to speculate that the Barclays spin on the crisis is designed to forestall such a reaction.

All of this is to leave aside the sorry history of nationalisations in general. I need not detail the long history of how nationalised industries end up as bloated corporate welfare institutions. Whilst there have been a smattering of successes, the majority of nationalised industries turn into long term drains on government finances. With the appalling state of the nationalised banks, combined with government use of the nationalised banks to achieve broader national economic aims, what chance do these banks have of ever achieving commercial success?

The most worrying aspect of this is that the idea is now spreading around the Western world. Euro zone countries and possibly the US (in a modified form?) are using the UK solution as a template for their own 'rescues' of the financial system. The idea that the rest of the Western world is following a solution like this is very disturbing. Yet again, it is a continuation of the delusions that have been driving the economic policies of the governments in the Western world. Yet again, more debt, more borrowing from the rest of the world, is seen as a solution. The idea that this is anything more than an attempt to reflate the debt based economy is the great delusion. However, the governments will point to the rise in stock markets as evidence of the success of their plans. Such a positive swing in sentiment will only be a pause, as economic reality will once again intrude on such misplaced optimism.

For regular readers, my analysis of this situation may come as no surprise. It is just a continuation of my argument is that the only real solution to the current crisis is long term structural reform that promotes real wealth creation for the economy. However, I have analysed the current crisis from a different perspective, which faces the reality of the changes that have taken place in the world economy, and this is why my analysis differs. Furthermore, I have posted many times suggesting that the US and UK economies are actually structurally bankrupt. These nationalisations have seen the government of the UK take on ever more liabilities, and this will stretch an already dangerous financial position ever faster towards the breaking point.

Perhaps the most shocking part of all of this is that the nationalisations seem to have very broad based support. The only explanation for this is an ongoing desire to stick our heads in the sand, and hope that the underlying economic problems will just to away. As I put in the title, just a continuation of the ongoing delusions.....

Note 1: I have had a comment from 'LordSidcup' (name from the Jeeves novels, I believe) asking a question as follows:

What better alternatives can YOU suggest that Gordon Brown should do in the short to medium term

My answer to this is simple. There is no short term solution. I once made a comparison with governments and King Canute trying to turn back the tides (Canute knew he could not actually do this). If I might stretch the analogy a little, this is like trying to build a wall of sand on the beach to turn back the tide. Just as King Canute knew that the tide could not be turned back, so do I. This is not 'defeatism' but recognition of the reality. Some number of posts ago, I made the comparison with a household on the threshold of bankruptcy, and how tempting it was to put off finally facing the reality with a last big loan. It is not changing the real problems that they have to face, that they do not make enough money to cover their debts and expenditure, and that they really just need to accept their real financial position. The new loan will just prolong the pain that bit longer, and leave them with ever greater problems.

I have proposed some solutions which will take a few years to really impact the system in any significant way, some of which can be found in the links at the top of the page. For the short term, there are some fast 'hits' that can be made, which may be able to help government finances. A long time ago, I started reviewing the comprehensive spending review, but only managed 1 of the 2 posts before events distracted me. One of the purposes was to look at where tax money actually goes, and to identify the most obvious areas of waste to be culled. However, in light of my not having done this, I can only suggest a look through the 'Taxpayers Alliance' website, which looks closely at waste. However, I must emphasise that these savings will do nothing to 'save' the economy in the short term, but are a good start for hastening recovery in the medium term.

The simple answer is that, one way or another, there is nothing that can turn back the tide, and governments should be concentrating on how they will manage a recovery and a return to the business of real wealth creation. I note that there was accusatory 'YOU' in the post, suggesting that it is easy to sit on the sidelines and criticise. I hope that, if you read my solutions, you will see that it is not for the lack of imagination that I offer no solution. I am not offering any soltuions because of an acceptance of the reality of the situation. The reality is -

Wealth is made - not borrowed money or something imagined into existence.

Keep this in mind, and the walls of sand being built on the beaches will be seen for what they are.