UK Debt - Is it a problem?

Note: I have made an error below - the second comment was not Arlo, but another person. Apologies to Arlo and the other poster for the confusion. I have left the post as it stands, however, as I was trying to address the themes in both comments (I have to admit that the two perspectives did not quite tally, so should have realised).

Original post below...

I have had two comments from a 'Arlo' in my post 'UK Bankrupt?' which I think I should respond to (apologies for the time taken, but my 'real life' is rather hectic at the moment). Arlo has made two challenging comments as follows:

'This raises the philosophical question of whether you can "realise" something that isn't true.

UK has a big external debt but is also a big external lender. Whether we're bankrupt or not depends on the net position. UK external assets are about 95% of UK external debt, so the problem is about 5% the size you claim.

Your 18C aristocrat has a portfolio of shares almost as large as his debt, so his net annual payments to creditors is a tiny fraction of his income from non-financial activities (GDP). That's why they keep lending to him.

Sorry it's not as exciting as a financial apocalypse, and it doesn't really add much to big-picture arguments about a postindustrial economy or whatnot. But that's accounting for you.'

And

'If the 18C aristocrat had a load of shares he could cash in, why would he borrow money at interest? Wouldn't he use up his cash first?

With regards to the UK, what happens if the people 'we' have been lending money to cannot repay the loans? Presumably we are still liable for the 12 trillion dollars in debts?'

Note: For new visitors to this blog, I would suggest that you read my essay 'A Funny View of Wealth' before continuing here. The essay is quite long, but I hope it is worthwhile.

The first thing to say is that I appreciate comments, and enjoy challenging ones. With regards to the current state of the UK's net position, according to a paper by Whitaker (1), the position is as Arlo describes. According to the paper, the following is the case:

'Official data suggest that the United Kingdom’s financial liabilities exceed the value of its financial assets — net foreign liabilities were equal to around 14% of GDP at the end of 2005.'

The only problem with this rather rosy scenario, is the nature of the financial assets. In particular many of the assets that the UK can point to are actually assets owned by UK based companies, representing foreign direct investment (FDI) or portfolio investment, and those companies are not necessarily UK owned. This may present some problems. The first is that the companies may be based in the UK, may be listed on UK stock markets, but that does not imply that the ownership is UK based. Are the figures for FDI calculated on the basis of the companies being owned by UK individuals, or are they calculated on the basis of UK based companies? I suspect the latter and that means that many of the UK's overseas assets are not actually UK owned (I am open to being corrected on this, but I believe this to be the case).

Of course, we could make the same point as the above for other countries and ownership of assets, but the important point to make here is that the UK economy is very open, and the UK has had one of the highest levels of inward investment of any of the countries in the world, suggesting that the UK will be in a position where international ownership of companies is particularly high.

The second is that a company is not tied to the UK, and has the freedom of relocating itself to another country where there is a better business environment. This has recently been happening in the UK, with companies relocating to Ireland for example.

Another problem is that our net assets are largely based in Europe and the U.S. and I have discussed at length the underlying problems with the OECD economies, in particular the U.S. and Europe. As such, these assets are not necessarily going to hold their value. For example, it will be interesting to see what happens to the value of commercial property held by the UK in the U.S. However, set against this, the value of assets in the UK will also drop, as will the return on those assets for overseas investors.

Another problem is the question of how the figures are calculated, which is in part why I have cited Whitaker. He points to the following rather strange effect:

'net investment income has improved at the same time that the United Kingdom has become more indebted'

By way of explanation he says the following:

'Two factors are behind the United Kingdom’s ability to obtain net investment income despite increasing net indebtedness. First, the yield that the United Kingdom pays on the bonds and equities issued to overseas investors — termed portfolio debt and equity — appears to have declined relative to the yield that the United Kingdom earns on the bonds and equities issued by the rest of the world that it owns. Second, there has been a shift in the composition of UK external assets towards foreign direct investment (FDI). FDI assets generate a higher yield than the United Kingdom’s predominantly debt-like liabilities.'

To quote my own tag-line 'I just don't buy it'. It just seems too close to the idea of 2+2=5, but my purpose here is not to discuss his thesis. Interestingly, he also acknowledges that the figures that are used for the paper are somewhat problematic, but believes that they are understating the UK's assets.

Another way of looking at this is the current state of the balance sheet of individuals in the UK. With regards to debt, it is no secret that individuals in the UK have shockingly high levels of debt (see here for an example break down - it is out of date and therefore understates the scale of the problem, but is interesting nonetheless). On the other side of the balance sheet, savings have been falling back and are at the lowest level for 50 years, such that on a chart the lines are going in the opposite direction (see here - sorry, again out of date as I am as ever pressed for time, and it is the first useful chart I could find, but hopefully you will get the picture). Savings represent the accumulation of assets, both in the UK and overseas. As such, if the savings rate is low, there will be a commensurate drop in aggregate ownership of overseas assets by individuals in the UK. What we are therefore seeing is increased borrowing by individuals, and a significant proportion of that from overseas sources (the sub-prime crisis has demonstrated the international nature of lending to consumers), compared with less investment overseas.

A good summary of the state of the UK household balance sheet can be found here (an IFS powerpoint presentation). Whilst it shows a positive overall balance sheet, the trouble is that it is a snapshot of the value of assets, and does not account for a downward spiral in the OECD economies. As the banking system has discovered, even the Basel capital adequacy ratios can not assure assets can be valued accurately - until it is time to sell them. It is here that matters become complex, because we have a situation of mutual interdependencies. The balance sheets of households are dependent upon the overall state of the economy in the OECD, and the state of the OECD economies is, in part, dependent on the balance sheet of households within the OECD. What happens when, for example, stockmarkets fall? Or what happens when the value of assets such as housing fall? What then happens is that the interdependencies kick in, causing a downward spiral. As I have pointed out, most of the overseas assets held by the UK are within the OECD, with particularly high exposure to the U.S. and Europe. Throw in the complication of an abstract idea of confidence, and there are ever more feedback loops that will push the economies downwards.

If we actually look at what has been happening in the UK we see consistent balance of payments deficits over a long period of time, and even invisible earnings are now in deficit. I have already discussed inward investment and questioned whether it is a 'good thing' in 'A Funny View of Wealth'. This is now reflected in our position on invisibles.

'The continued weakness of manufacturing exports and the strength of import demand, fuelled by the consumer spending boom, have led to a widening current account deficit, put at £57.8 billion or 4.2% of GDP in 2007, not far short of double the level of £30 billion two years earlier. Indeed, the deficit would have been closer to £70 billion but for a surge in investment income in Q4, a one–off result due to the impact of the credit crunch as foreign banks posted record losses. The surge in the deficit is largely the result of consumers living beyond their means, lured into more spending by offers of cheap credit, in turn sucking in greater imports. As a result, the merchandise trade deficit widened to £87.6 billion (6.3% of GDP) last year from £77.4 billion (5.9%) in 2006, with the deficits for finished manufactured goods, basic materials and food, beverages and tobacco all rising significantly. But, at the same time, the current account has also been hit by falling net invisible earnings. The deterioration in portfolio investment income has been fairly modest but the traditional surplus on the income account fell to £5.3 billion in 2007, far below the level of £25.8bn just two years earlier, primarily the result of sharply lower net inflows of direct investment income (although the latter rose to £37.5 billion last year after the very strong Q4). On top of this, net outflows of transfers have continued to climb, reaching nearly £14 billion compared with around £12 billion in the two previous years.' (2)

Looking at another part of the equation, UK government debt is fixed an firmly attached to the UK. Also, if we look at individuals, there is considerable outward migration from the UK. As I have discussed in my essay 'A Funny View of Wealth', those migrants will be taking all of their assets with them. They are very unlikely to be in debt, whereas the state of individual debt in the UK is, as is being widely discussed, parlous. This debt is also firmly attached to the UK as these individuals are unlikely to leave the country taking their net debt with them. In short, for individuals, those in debt are tied to the UK and those that are leaving are taking their net assets with them. Unlike the assets held by companies, that are able to relocate, or where those assets are often partially owned by overseas investors, the consumer and government debt are not going to go anywhere. They are 100% UK owned debts.

Quite simply, as I have discussed in 'A Funny View of Wealth' the UK economy has been supported by a net increase in debt, and sterling has been supported in part by a flood of inward investment. However, as I pointed out at some length, such inward investment is not necessarily a good thing, unless it is investment in business that generates income from outside of the UK.

As I have stated previously, the UK economy is in a very, very bad position. I have mentioned before the problem that we include in GDP economic activity that is resultant from increase in debt. This makes the UK economy appear much larger than it is in reality. As such, whilst it may look like we have a size of economy that might be able to service our liabilities, the simple fact is that, when an ever growing debt mountain is stripped out of the GDP (remember the multiplier effect), then the UK economy is actually going to be nothing like the size it is reported to be.

We have massive external liabilities, and I do not believe that we have the ability to service these liabilities. We have assets that are declining in value, a negative net income, fast expanding government debt, a shrinking economy that MUST shrink back to a level with debt growth stripped out, and increasing competition in the few sectors in which we have competitive advantage, and finally the (albeit illusory/temporary) support of inward investment is disappearing.

To quote Arlo again:

'Your 18C aristocrat has a portfolio of shares almost as large as his debt, so his net annual payments to creditors is a tiny fraction of his income from non-financial activities (GDP). That's why they keep lending to him.'

The first question is who owns the shares? Even if he does sell the shares that he owns, then there is still not enough to cover his liabilities. The second point is that, even if they were all sold, his income does not begin to cover his expenditure. There is no prospect of his income increasing, so creditors will see no way of his paying back any future lending. The only way they will lend to him is if he savagely cuts his expenditure such that his income is enough to repay the debt. However, his income is actually declining, so who would take a risk on him?

As I have said before, the UK is structurally bankrupt. By this I mean that it is not clear how we can pay off our external debt in our current situation. This is why I am proposing structural reform.

(1) Whitaker, Simon,The UK International Investment Position. Bank of England Quarterly Bulletin, Fall 2006, Available at SSRN: http://ssrn.com/abstract=932523
(2) (2008). "Are the UK's twin deficits a risk to stability?" Economic Outlook 32(2): 14-19.

Other Useful references

http://www.bankofengland.co.uk/publications/quarterlybulletin/qb070401.pdf
http://www.le.ac.uk/economics/research/RePEc/lec/leecon/dp05-5.pdf
http://ec.europa.eu/economy_finance/publications/publication1449_en.pdf
Kirsanova, T. and J. Sefton (2007). "A comparison of national saving rates in the UK, US and Italy." European Economic Review 51(8): 1998-2028
Vladimir Klyuev, Paul Mills. (2007). Is Housing Wealth an "ATM"? The Relationship Between Household Wealth, Home Equity Withdrawal, and Saving Rates. IMF Staff Papers, 54(3), 539-561. Retrieved September 12, 2008, from ABI/INFORM Global database. (Document ID: 1330902681).

UK Bankrupt? Does the market now realise?

Despite suggesting in my last post that I would move on to a discussion of regulation in the UK economy, I thought I should make a quick post in light of some of the latest headlines.

The first comes from the Telegraph, and the article reports:

'It is the first time a major international forecaster has explicitly said Britain is facing a technical recession, in which the economy contracts for two successive quarters.

Even more embarrassingly for Gordon Brown, the OECD forecast shows that Britain is the only major economy in the world which will face recession in the next six months. The warning severely undermines his claims that the UK is well-placed to withstand the global downturn.'

This is very much in accord with my earlier post in which I pointed out that the UK is uniquely poorly placed to weather the economic storm. However, I do believe that the OECD is being far too optimistic about the prospects for the other OECD economies. However, this is not about finding further vindication for my predictions but mentioned as further evidence of the loss of confidence in the UK economy.

The OECD appears to be waking up to the severity of the situation in the UK economy, and the market appears to be doing the same. The £ sterling is continuing to plunge, as is discussed in another article in the Telegraph:

'The pound's slump accelerated for a second day in London as traders abandoned British investments following Alistair Darling's warning that the economy is facing its worst threat for 60 years.' and 'The slump leaves the pound worth the least - against a basket of world currencies - in 12 years.'

Again, this is much as predicted but, more to the point, is a strong indicator of the loss of confidence in the UK economy. Finally, and perhaps most disturbing is yet another article from the Telegraph which indicates the terrible state of the British banks:

'The City's embattled banks packaged up the biggest amount of mortgage debt in history last quarter, in a desperate scramble to gain access to the Bank of England's Special Liquidity Scheme.'

The big question here is whether the UK government has accepted toxic waste from the banks in an effort to save the banks, or whether the swap was made against sound instruments. Even more pertinent is the question of the state of the UK banks in general. Many of these swaps have been made during the relatively 'good times', and this raises questions as to how bad the state of the banking sector might be now that times are getting tougher and tougher. I have suggested that there will be a further credit crisis in many of my posts, followed by a rash of bank failures, but perhaps the carnage will be greater than I previously thought.

I have quoted these articles and posts to highlight the gradual and accelerating loss of confidence in the UK Plc financial position. I have pointed out before that I believe that the UK is structurally bankrupt. By this I mean that the UK's ecternal debt exceeds the ability for the UK to ever repay the principle, and that it is increasingly impossible to pay the interest. There is simply not the productive capacity for export to achieve this.

The reason why confidence is so important is best explained through an analogy. The analogy is an 18th century aristocrat who is living beyond his means. He gambles, he entertains, and he has a wonderful time. All of the tradesmen extend to him long lines of credit, and he continues with his profligate lifestyle, all the time feeling that he is above the petty business of managing finance. After all, his family has been wealthy for generations, and it is his right to enjoy the good life. However, he is actually spending his family wealth, and the earnings from his estate are no longer covering the costs.

His creditors also know that his family have a long history of wealth, they see his fine house, they see his expensive furniture, his lavish lifestyle, and can not believe that he will not repay the credit that they are extending.

Then a rumour starts that he is in financial trouble. One or two of his creditors start to press for payment, and restrict his access to new credit. He is unable to make the payments. The word starts to go around that maybe he is not as solid a credit risk as everyone first thought. Creditors start to refuse to extend his credit further, and the aristocrat starts to realise that he has no money. The entertaining, the lavish clothes, all become beyond his means. He can no longer make repayments. His estate does not generate enough cash, and now that the credit has stopped, he can no longer afford anything at all. He is bankrupt.

The UK has long lived on such confidence but, like the aristocrat, it is a misplaced confidence. It is a confidence built upon an idea that wealth is a birthright. However, as the UK is about to learn, it is not a birthright, but something that requires effort and energy. You can only live so long on your inherited wealth before it is squandered away, and you can only live so long on credit before the creditors start to ask questions of your ability to make payments.

It is for this reason that I am looking so closely at news that indicates loss of confidence in the UK economy. As I have said, the UK is structurally bankrupt, and it is just a question of time before all the creditors start to notice. At that point, the UK will visit the IMF....

Note:

On another indirectly related issue, it is apparent that the government is considering a stamp duty 'holiday' in an attempt to revive the housing market. As I have pointed out in a previous post this suggests that the government has some special knowledge about what house prices should be. I will not rehash what I have already written, but would recommend you take a look at the post. It will highlight how absurd such intervention in the market actually is.

More on UK Government Borrowing - The UK is Bankrupt

I have already posted once on this subject today, but thought I would add something more, as I have been giving some thought to the latest news on UK government borrowing. Having accurately predicted that there would be a crisis in government finances, I am still surprised by the speed of the collapse of the government's position.

As I pointed out in November, in 'A Funny View of Wealth', as the economy tipped into depression, government finances would suffer. It is both inevitable and obvious. As an economy turns down the sources of taxation shrink; VAT, income tax, corporation tax, stamp duty and so forth. At the same time costs will go up as unemployment rises and so forth. The situation at the moment is that the crisis in government finances has already started, but still at the point where unemployment is still in the early stages of the massive rise that will inevitably occur. In other words, if the government's financial position is this bad at this point, how bad can it get?

As I have mentioned, government will need to either borrow more, which will destroy confidence in the UK economy, or will require massive cuts in state spending. If it is the former, then the result will be destruction of confidence in the UK government's ability to manage the finances of the UK and the UK economy. If it is the latter, then there will be a strong downward lever on the economy (at least in the short to medium term).

I have been giving this some thought, and I am coming to a conclusion that it is going to become increasingly difficult for the government to borrow at all. I have detailed elsewhere that the £GB will continue to fall in value. I have argued that depression is looming. The government deficit it going to balloon. This makes lending to the UK government a very, very high risk venture.

My question is this; Will anyone want to continue to lend to the UK government under such circumstances?

I think that the answer, in the coming months, will be 'no'. I am not sure at what point this will occur, but I would guess that the turning point will come in the next six months or so. It is at this point that the government will really fall to pieces. The reason will be that, in the near future, the UK will be calling on the International Monetary Fund. Quite simply, with the huge risks in the UK economy, I simply do not believe that it is creditworthy, and others are going to come to the same conclusion.

Quite simply, the UK is bankrupt. Both consumers and government have borrowed more than they can afford.

It is like a household that has been borrowing to pay back previous borrowing. The household has been based in a good neighbourhood, and the household has continued to enjoy holidays, new cars, and all the luxuries of modern life. All this has been paid for with every increasing borrowing. Every month, more borrowing to pay back previous borrowing. Every month, the burden of debt has risen, but still the spending remains the same. Finally, the lenders will look at the household and notice that the amount of borrowing is creating a need for repayments that is exceeding earnings after expenditure. Do they throw good money after bad? The answer is, of course, 'no'. At some point they know that they must cut their losses. The UK is in a position where the earnings can not possibly meet the borrowing without severe cuts in expenditure, and there is only the prospect of decreased earning in the future requiring ever deeper cuts.

Time has run out on the UK economy. It is bankrupt. It will need to rely on the charity of the IMF. The IMF will demand that the UK government cuts expenditure. A wind of terrible change will have to blow through the UK economy.

Our analogous household will have to cut back, move into a poor neighbourhood, into a tiny run down house, and stop the spending on luxuries. The only spending the lenders will allow will be the necessities of life. It will be very tough. That is the price of reckless borrowing - having charitable lending bail you out, and biting the bullet of living within your means while you try to repay the debt. It is tragic.