China, Gold and the $US

In the current chaos in the world economy, with endless potential avenues of news to pursue, with ever more extraordinary actions by government, it is becoming increasingly difficult to pursue all of the points of interest that I am seeing. For example, I would like to dig around a little to find out exactly what the Fed is up to with quantitative easing (QE - Printing Money), and hope to cover this in the near future.

I decided that, for the moment, a greater priority would be to try to find out what China is buying with its amassed foreign currency reserves, as this is possibly the most important single factor at this moment in time in the future of the world economy. In particular, China has the potential to make or break the $US. In several posts I have speculated that China will seek to offload $US assets, and will divest as many as possible before markets take fright. China's main holding of $US is in treasuries, and any significant sale of treasuries from China (or possibly stopping purchase of treasuries) will see the $US fall dramatically - or even collapse.

I believe that the $US is looking extremely vulnerable at the moment, and it would not take much for a collapse in confidence. Of particular note is that Warren Buffet appears to have come to the same conclusion, with his discussion of treasuries (and therefore the $US) as a bubble. The recent collapse in the prices of stocks has seen a new surge into treasuries, as investors seek safety, so a prediction of a collapse in this market at this time might seem unusual. However, the action of frightened rabbits caught in the headlights of an oncoming truck might not be considered as an indication of what will happen when there is time for thought.

The steep falls in the stock market are simply another indication of the fundamental weakness in the US economy, and that weakness suggests that the $US must eventually fall. China meanwhile has a delicate balancing act if they are to exit the US treasury market. Any hint of a mass sell-off would lead to a collapse in the $US, and would destroy the value of a large swathe of their reserves.

Within this scenario there is a major question that needs to be answered. If China does start to dump US treasuries, where will they hold their reserves?

The two most obvious contenders are the Euro and the Yen, but both are problematic. With regards to the Euro, this is looking increasingly unstable, though with some potential to buy into the government bonds of countries like Germany. Japan, as ever, I find difficult to fathom, but the speed and depth of the collapse of their export machine does not encourage much confidence. If China does exit the US treasury market, it is not immediately obvious where they might want to put their money. I have had several readers of the blog ask me where they should put their money, and China is in the same position as those investors but on a different scale.

The key difference that arises from such scale is that China has the potential to massively impact upon any market with which it is involved. The sheer size of their reserves means that they can swing any market up or down according to their actions. Aside from this difference, which requires a circumspect approach from China, I would probably find myself having made the same recommendation that I made to individuals nearly a year ago. This was that gold was the best prospect and an asset that might survive the turmoil (though I offered many caveats to this advice, as I am not an investment advisor).

The position of China as a potential maker or breaker of a particular market means that China will act in a way that is as opaque as possible. Even a hint that it is planning to exit treasuries would possibly see a rout, and any hint of entering a market likely to see asset prices rise. However, it is possible to pull some pieces of news/information together, and try to work out what China might do.

This is no easy task as we have the mixed messages coming out of China. For example, back in February, we have the now famous statement from the Chinese authorities on US treasuries, expressed in the following colourful language:

Even at the elite level, the sense of frustration occasionally bubbles over. "We hate you guys," Luo Ping, a director-general at the China Banking Regulatory Commission (CBRC), complained last week on a visit to New York. "Once you start issuing $1-$2 trillion . . . we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do."

The same article goes on to say:

As China's economy slows sharply, the debate on how to manage its reserves is intensifying. Some propose spending the money at home; others want more diversification of investments. But the consensus behind recycling foreign currency into US government securities is coming under attack.

Essentially, China has expressed awareness of the delicacy of the position of the $US, but has still suggested a commitment to $US assets. The US government is clearly nervous of the situation, as can be seen in Hilary Clinton's begging bowl mission to China, which took place with unseemly urgency. Whilst China is making reassuring noises, this does not necessarily indicate China's actual intentions. As I have mentioned in previous posts, it would be likely that, even if selling treasuries, China would still make reassuring noises to prop up the value whilst they were undertaking the sales.

In one respect, China has been relatively open. It has made it clear that it expects that the US will follow a sound monetary/fiscal policy, if it is to continue as a buyer of treasuries:

The U.S. “should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way,” Yu, who now heads the World Economics and Politics Institute at the Chinese Academy of Social Sciences, said in response to e-mailed questions yesterday from Beijing. He declined to elaborate on the assurances needed by China, the biggest foreign holder of U.S. government debt.

It is here that we encounter the current policy of the US government. We have now had the first Obama budget. This budget was notable for considerable rhetoric on responsibility by Obama, but was lacking in any credible plan on how to reduce the budget or current account deficits. The actual substance of the budget was a massive expansion in deficits, and the budget therefore simply adds a new driver to the massive increases in US indebtedness that has resulted from the various bailouts, stimuli (monetary and fiscal), and the other many drivers of ever mounting borrowing. In total, the current US policy might be summarised as an expansionary spending binge, with no clear plan on how to pay back the borrowing . This will hardly conform with Chinese expectations of protecting their investments, and the Chinese government will surely not be taken in by Obama's rhetoric.

As such, if the Chinese were not simply trying to influence US policy with idle threats, it seems unlikely that they will be willing to continue to support the US economy with further lending.

Note: I was just set to publish the post and came across yet another article saying that the bail out in the US is expanding yet again, with Bernanke proposing more money to 'save' the banking system. At what point will anyone think 'enough!' Whatever the severity of the problem, the answer just keeps coming back - just pump in more money, at whatever cost....

With regards to actual Chinese activity, it is apparent that Chinese treasury purchases were already slowing in January, with some analysts suggesting that the mix of assets held have been altered in preparation for a fast exit from treasuries:

The U.S. Treasury’s international capital statistics showed that in November, China’s net holdings of long-term U.S. Treasury securities fell by more than $9 billion. However, the country’s short-term holdings rose by $38.2 billion. Determining the motivation here is difficult — it could simply be that China followed the rest of the crowd in jumping headlong into the safest securities possible, or more worrisome factors could be at stake.

“When any creditor shortens the term structure of its holdings, the borrower should probably be cognizant of that, because the creditor is giving up yield to give itself the option of exiting quickly,” says Brad Setser, fellow at the Council on Foreign Relations. “That’s one way to interpret the shortening of the structure of China’s holdings.”

A you would expect, I have tried to get some hard figures on what China is actually doing at the moment with treasuries, but have been unable to find any sources of this information (links/comments welcome). As such, I am unable to provide any firm information on the actual situation, which is rather frustrating. The same can be said for the Chinese position on European and Japanese bonds. However, with regards to European bonds, it seems unlikely that China has been moving out of treasuries into European bonds, as there have been problems in the sales of bonds in many auctions in Europe, even including German bonds. Had China been shifting holdings into these markets in any significant way, then such outcomes would be unlikely.

On the other hand, it has become apparent that China has been dabbling in the US stock market, and has therefore seen significant losses with the plunge in US stocks:

Provisional figures from the US Treasury department showed that Beijing was holding $99.5bn of shares in June 2008, up from $29bn in 2007. Two years ago, China only held $4bn in US equities, preferring to concentrate on Treasury bills.

However, economists said the latest figures suggested that China may have bought as much as $150bn of equities worldwide, or 7pc of its vast foreign exchange reserves.

Brad Setser, an economist with the Council on Foreign Relations, a US think tank, said the State Administration of Foreign Exchange (SAFE), a branch of the Chinese central bank charged with looking after the foreign reserves, was responsible for the buying spree.

This outcome might signal a return to treasuries, but just as likely might be a warning to China about the risks inherent in remaining in the US. Either outcome is possible, but I believe that the latter outcome will certainly be a consideration in the thinking in China.

Finally, we come to gold, the other possible asset that China might consider as a safe haven for their reserves. As I dug around, it became apparent that China has been beefing up gold investments for quite a while, as well as having a booming gold mining industry. Overall Chinese demand for gold is now the second highest in the world, with tantalising hints (unsubstantiated - see original article) that China is actively beefing up official reserves as well. However, before we get too excited that China will dump treasuries for gold, one analyst points out the following:

What about gold? That one’s easy: it’s estimated that all the physical gold in the world that’s ever been produced amounts to roughly 140,000 tons (worth about $4.5 trillion dollars using $1,000 an ounce). About 75% of that is either in coins or jewelry… not available to China, or to any other government.

The new gold available each year is miniscule: about 2,600 tons (almost $83 billion dollars worth) of new gold is being mined and refined annually, increasing the total supply by 2% per year.

You can see that China’s problem - if it wants to invest in gold as a diversification strategy - is that there isn’t enough available for sale. 30,000 tons are held in various government central bank vaults. Privately held bullion amount to about 20,000 tons.

Any major purchase of gold on the open market - which is where China would have to buy it - would drive up its price. To put this in perspective: China buys enough U.S. treasuries in one month to pay for all the gold mined in a year everywhere in the world.

I mentioned at the start of the post that gold represented a good opportunity for China, but there are limits to how far China might take such a policy. The same might be said for other precious metals. However, it does seem quite likely that precious metals will play a larger part in China's overall mix of assets. This still leaves the central problem of what else China might move into, if it moved out (is moving out of?) of US treasuries? The same analyst who points out that China can not shift into gold, also argues more broadly that there are no credible alternatives to US treasuries.

However, the analyst makes a basic error in thinking that China would have to take an all or nothing approach. He does not consider that China might spread their reserves over a wide range of assets, and this is my best guess for the direction of China's policy. If they follow this strategy, and implement it with care, China has the potential to rapidly jump towards becoming the world's most powerful economy.

The first step is to manage the sale of US treasuries with the greatest of care, such that they gain as much value of the sales as possible before the $US collapses. As they move out of $US they would likely buy as many precious metals as possible without driving the price too high, as well as buying into emerging market, European and Japanese bonds. In doing so, they will be taking risks but with the benefit that they will be positioning the RMB as the next reserve currency. Furthermore, it is no secret that China has been trying to buy into various commodity companies (or natural resource companies), such as the ongoing saga of the Chinalco purchase of Rio Tinto or their wider expansion of investments in this sector.

When the markets finally do spook, and the $US falls, China would need to keep selling hard into the market until the $US reaches a planned point at which China will halt further sales. I have no idea where that halt might be against what, but would guess that at the very least (whether I am right or wrong about the overall picture) China will have made contingency plans. With such large holdings of $US and the abysmal state of the US economy, it is hard to imagine that there is not an exit strategy for China.

Assuming that I am correct (a big assumption) at this point the US and OECD economies will probably go into a state of crisis, with stock markets collapsing and a wider state of panic amongst governments. Whilst the OECD governments will (I guess) have contingency plans for such an eventuality, there will be nothing that can be done to halt the slide when it happens. It is quite possible that there will be plans in place to support the $US in the event of a slide, in both Europe and Japan. However, I do not think anything will halt the slide once it starts.

With the US in shock, China can then use the remaining holdings of $US to go on a shopping spree into the US. In particular, China can offer to enter the markets with an offer of salvation - but at the cost of unopposed access to purchase the companies that might provide a leap into the high added value industries with technology or specialist skills. They will not put it this way but, in a climate of economic panic, they will be in a position of calling the shots, as the only significant player able to halt the slide. As a result of the panic, they will be able to buy even good companies at fire sale prices. As such, they will be able to use whatever $US assets they still hold to take a major leap up into added value industries.

Inevitably, such a large fall/collapse in the $US will see the undermining of the status of the $US as a reserve currency. The Euro is now in a position of such instability that it will not have the potential to act as a replacement. The Japanese Yen might have some potential as a replacement, but the RMB will be better positioned as the strongest contender. In particular, the Japanese will likely act to rescue the $US during the crisis, but will fail to stem the tide, and undermine the credibility of/weaken the Yen in the process.

If China was to follow such a course, it would put itself in the position of being the major world economic power, or would do so at least in principle.

So far, so gloomy and so apocalyptic......Astute readers may realise that this is all very highly speculative, and misses the underlying flaw in the whole strategy.

The flaw is that, if China were to follow such a course, it would also risk self-destruction. I have discussed this problem in many previous posts. The problem for China is that it has built its economy to service Western economies through high levels of exports. As such, if there is an economic collapse in the US and Europe, China will also destroy the markets for its goods. In doing so, it will see a massive contraction in the export sector of its economy, with a commensurate explosion in unemployment. The Chinese government is almost certainly aware of the fact that their legitimacy rests upon economic growth and nationalism, and that any dramatic fall in the economy might cause significant social unrest, including the possibility of major revolt.

Whilst this might suggest that China must continue to support the $US, in order to keep their export machine turning, it is not clear that this provides a solution for China. It is becoming increasingly clear that, whatever China itself does, the US is rapidly sinking into a quagmire. Under such circumstances it looks increasingly likely that the US is in any case collapsing as an export market and that, even without any action on the part of China, the $US must eventually sink. Whilst China can continue to prop up the US economy in return for increasingly worthless bits of paper (in exchange for the labour of their population), the US economy must in all cases eventually see a considerable contraction.

China is therefore faced with a choice of an all or nothing approach - or letting the US rapidly decline whilst they pursue a futile policy of trying to prop up the unsupportable. In one case they have an opportunity to extract the maximum remaining value from their reserves, and in the other they will simply pour more of their resource into a black hole.

I must emphasise that this is all speculation, as I do not know what the Chinese are planning, and what they might do in the current situation. China being China, it is hard to ever discern what their actual plans might be, as they lack any form of transparency whatsoever. However, it does seem that they have some hard choices on the best way for them to deal with the economic crisis. Whatever they do, they risk social instability, and even the possibility of major social unrest. Whichever direction they take, they will be entering into a high stakes game, with the potential for chaos should they make the wrong choices.

In all of this speculation, I am also making an assumption. The assumption is that the current US policy must mean that the $US will eventually collapse. I simply do not believe that a massively indebted country with very little in the way of savings, a massive current account deficit, can get out of trouble through an explosion in new borrowing and massive increases in deficits. It might be argued that this is simplistic, but I make no apologies for taking such a straightforward approach. However, with every new bailout or stimulus, the economic situation of the US just seems to deteriorate further. I think that China will be observing this and will take note of the fact that nothing seems to work in stopping the US economy from collapsing.

I can imagine that, within the closed world of Chinese policy making, there will be some heated debates on the best course of action. If, and it is a big 'if', I am correct, then it appears that the world economy is on a knife edge. If China is debating the position of the $US, they will be aware of the risks in waiting compared with the risks of acting to preempt the slide. Whilst I admit to being speculative in much of the post, I can not believe that China is not discussing this subject and, if there is a discussion about the risks, there will certainly be contingency plans. The big question is - which way will they jump?

(alternative scenarios welcomed in the comments section)

Note 1: For regular readers, they will be aware that I have long been expressing my concern both at the policy of QE (Printing Money), and the opacity of the policy with which it is being undertaken. I have recently written to the Bank of England (BoE), requesting some details on the policy, and have encouraged readers to write to their MPs asking for more information (see note 2, I have copied a suggested letter).

My concern has been that the most radical policy ever undertaken by the BoE, with potential for profound effects on the UK economy, has seen no detail of how the policy will be undertaken, without even any discussion of how much money will be created. Furthermore, in the information provided, it is clear that there is no formal mechanism for reporting what is taking place.

The bottom line is this. At present there is absolutely nothing provided by the government or BoE to distinguish what is going on from what happened in Zimbabwe.

A short while ago I received a letter from a BoE Press Officer requesting a 'chat'. I have now had that 'chat'. The summary of the conversation is that no further detail on the policy will be provided until the publication of the letters between the Chancellor and the BoE which discuss the policy. Whilst the BoE press officer was inevitably polite, he cast no light upon the policy. A long conversation amounted to 'wait for the letters to be published'. The only point of substance was a suggestion of a possible means of reporting the QE activity, but this was not an official statement of intent.

The worrying part of this is that this means that the first we will know anything about the policy is when it is actually implemented. As such, we will be seeing one of the most radical economic policies ever undertaken implemented without any discussion of the details of the policy prior to implementation. The idea that a policy with such magnitude of potential consequence for the wider economy should be undertaken in circumstances of such opacity is quite extraordinary.

The BoE letters are apparently going to be published very shortly, so I will await the publication. If they fail to clearly answer the questions that I have asked, then I will continue to pursue this matter as far as I can, including putting as much pressure on the BoE as possible. Whilst this blog now has a large readership (which is gratifying) I would also urge you to write to your MP requesting greater transparency.

To date I have expressed the view that QE is a method of financing government operations through the printing press. I have argued that the UK government is aware that it will have problems raising the money to finance operations of the government. As you will have noted in the above post, raising money through bond sales is becoming increasingly difficult. It seems more than a coincidence that, at such a time, the printing presses are about to start running. The opacity of the policy just serves to confirm my worst fears.

As such, when I review the BoE letters when they are published, my aim will be to closely analyse exactly what they commit to, and whether they leave any 'wriggle room' for either the BoE or government on the issue of full disclosure of exactly what they are doing with the policy.

Quite simply, this policy has the potential to wreck the UK economy, and I have seen nothing to date, and heard nothing to date, that offers any reassurance.

Note 2:

You can find the email address for your local MP here (click on the map for your constituency).

This is is my suggested letter which you can copy and paste, or alternatively write your own version:

-------------------
I am writing as I have very increasing concerns over the recent Bank of England policy to implement quantitative easing. In particular, I am worried about the following:

1. There is no policy document that clearly outlines how this policy will operate, what quantity of money will be created, what assets the money will be used to purchase, and what method will be used for the purchases.
   
2. In addition to this Mervyn King has suggested that the method of reporting for Quantitative Easing will be through the MPC minutes. This is not the purpose of the MPC minutes, and there is no requirement for full disclosure of activity in such a method of reporting.
   

This is all very opaque.

I am very concerned at such opacity in consideration of the fact that the Bank of England will be using money creation to purchase gilts. In this situation the Bank of England will therefore be creating ('printing') money to purchase government debt. This might be seen as government operations being funded by printing money.

Under such circumstances, it would be reasonable to expect the Bank of England to offer a transparent and detailed discussion of the policy as a formal policy document, as well as a formal, full and transparent procedure for reporting their activity.

I would therefore be most grateful if you could, on my behalf, seek to clarify why this process is being undertaken in such an opaque manner, and clarify exactly what the policy will be. I would also be grateful if you could press for a proper method of reporting on the policy of quantitative easing.
------------

Additions, suggestions for improvement will be welcomed. Just leave a comment below.

Note 3:

I predicted a while ago that the £GB or $US would collapse within three months, and that after the collapse of one, the other would follow shortly after. I am still convinced of the extreme fragility of the economic situation for both countries, and still think that I may yet be right. I have not checked the exact date I made this prediction, but I think I still have about 2-3 weeks to run before I am wrong.

I have been wrong about the $US before, and hope that I am wrong again this time. However, it seems that others such as Warren Buffet are also expressing concerns about the sustainability of the $US (if treasuries go, the $US will follow). I still think it will need an external shock to kick the $US down, but am becoming less certain of this. If I am right about China (a big 'if') then it might be that China will precipitate the fall...

Note 4: An interesting reply to one reader's request to his/her MP on the subject of QE (I assume using my standard letter). I will quote it in full, as it is more than a little disturbing:

'Have sent a copy of the letter to my local MP (Labour, Scotland). His reply:
Thank you for your email and I do appreciate your concerns at the current economic crisis. I am quite unsure as to the alternative that you believe may help steer our financial institutions out of the current mess?!'

That an MP can send such a reply sends shivers down my spine. If we take even a modest interpretation, we are getting a response that says that this is a desperate gamble.....

Note 5: There have been lots of comments on my post on the underlying cause of the economic crisis. I have has a further request from Josiah Stamp's Ghost and Jonny for some kind of forum, and will try to look into this at some point in the future. I am not sure that there is sufficient critical mass of readers (yet) to support the forum, but probably not far off. However, finding the time is not easy...

ChasH makes an interesting point, suggesting that offshoring might mean that there will be continued decline in strong companies in the OECD. I think that, once the balance of labour costs adjusts, this process might come to a halt as the cost versus benefits will alter. However, we will see...

Some interesting points of view from Lord Keynes, which I would like to address at some stage, time allowing. Lord Keynes appears to the devil's advocate amongst the commentators, which is useful to have on the blog. It is good to have challenging views.

Also, thanks in general for some interesting and stimulating links, which I nearly always follow up (I do occasionally miss one or two). One stood out as I already think highly of the author, which is as follows:

http://www.niallferguson.com/site/FERG/Templates/ArticleItem.aspx?pageid=203

Niall Ferguson is very astute, though I do not agree with everything he proposes. I am currently awaiting the arrival of his recent book on the history of finance, which may be an interesting read. If it is as good as I think it might be, I will let you know....

Sorry, yet again a quick review on the comments. I have taken a part random sample on this occasion, and will try to continue to address as many comments/questions as possible. I hope I will be forgiven, but I have had to devote quite a bit of time to posts recently.

Note 6: It occurs to me that this post is very speculative. I hope that it is seen in this light, and other scenarios/views on what might happen next are welcomed, as well as any critiques of my scenario.

World Economy - What Happens Next?

As I mentioned in my last post, I thought it might be worthwhile to take a pause from the news and try to pull together what all of this means. By coincidence I finally had time to read my copy of the Economist from last week, which included their review of the situation. It was surprising to see how far they had moved towards the interpretation of events discussed in this blog. However, in several critical respects they differ.

For example, the Economist is broadly supportive of the bank bailouts and coordinated action of governments to try to fix the crisis. Across many posts I have listed many reasons to be against the bailout, so I will try to summarise the reasons for why this is an error. In one post I illustrated why this was a bad decision with an analogy of a family. The family have been spending more than their income for many years, and were already in severe financial difficulties. They are increasingly reliant on borrowing to sustain their lifestyle, are using borrowing to pay back previous borrowing, and are slowly but surely heading to bankruptcy. Meanwhile, the husband is having his working hours reduced, and the mother is facing the possibility of redundancy. In other words, their income is about to drop. In such circumstances, who in their right mind would suggest the solution is to borrow yet more money? The answer is obvious - nobody would give this advice. Instead, the advice would be to accept the reality of the situation, and tell them that they urgently need to change their lifestyle such that they can live within the means of their income. Ideally, they would also need to change enough to start paying back their debts.

For some reason, when it is a country in this situation, the solution to the problem is to borrow more money, the method of financing the bank bailout. This is the simple reality. Nobody disagrees (now) that the Western economies, in particular the UK and US, have been borrowing more money than was sustainable, but for some reason it is acceptable to get out of the situation through increased borrowing. Rather than accepting the reality that we must live withing the means of our (diminishing) income, the solution is to just borrow more money.

In a more recent post, I asked what the borrowing would be used for. We know that the money is being pumped into the banking system, but to what end? Were it to be used to invest in wealth creating assets, then I would have no argument with the Western governments extending their borrowing (whilst they still have the means to do so). However, the news suggests that the purpose of the bailouts is just to pump new sources of credit into the wider economy. In other words, it is just being pumped in to restore the supply of money to maintain the 'service based economy'. Will this money see the development of manufacturing companies, or be used for investment in new plant or technology, or be invested to develop services for export? There is no indication that this will be the way that the money is used. It is just an increase in overall debt, and is digging a deeper hole for the economy to sink into.

Governments are claiming that they will eventually recoup the money that they are lending, but the reality is that they will be encouraging the banks to lend the capital that they are injecting into the system. In so doing, they will be encouraging lending into a failing economy, which means lending against devaluing assets, lending to consumers who are increasingly likely to made unemployed, and businesses with ever greater risk of bankruptcy. In other words, the money will be used for lending into high risk, and will therefore see yet more mis-allocation of capital. In encouraging lending for the wider economic good, the governments are likely to just encourage yet more bad debt to be developed.

We then come to the question of how the money will be repaid. In my early posts on the bailouts, I emphasised the fact that this is spreading the damage done to the financial system into the wider economy through the necessary (eventual) increases in taxation. This means that the genuinely productive parts of the economy will be saddled with greater taxation, and will reduce their ability to compete. In other words much of the money being borrowed will be poured into the non-productive parts of the economy, and the cost of the borrowing will hurt those parts that have genuine wealth creating capacity. It is a recipe for long term economic damage.

So what is the bailout actually for? There is endless talk about restoration of 'confidence'. This is a very curious idea. What is the point of confidence? Does it produce wealth, does it change the underlying economic circumstances? The reason that there is no confidence is for the very reason that the underlying economic circumstances are so poor . As such, the $2 trillion being used to prop up the banks in the Western world is being used to create a false sense of confidence. This is a frighteningly irresponsible way to utilise this money, as the restoration of confidence can never be anything more than temporary, because the underlying economic reality is so poor. As it is, these massive borrowings being poured into the financial system are not even achieving this foolish aim in the short term. The rate of interest for inter-bank lending is barely moving, stock markets are still teetering on the edge of collapse, and so forth. At this stage, it is impossible to say that there will still not be an upturn in confidence, but such an upturn is unlikely, and in any case will eventually be destroyed by ever more bad economic news. (Note: I discuss why the value of money is built on confidence here, which would suggest that confidence is important. This may seem self contradictory, but the reason it is not is that confidence must have a foundation in economic reality)

So where does this leave the economies of the Western world? At the moment, the rest of the world is still lending into the Western economies. I forget which was the post in which I made this analogy, but this is a situation like the creditors to an 18th century aristocrat. His family has always been wealthy and his creditors continue to lend money in the belief that he will always be wealthy. However, the reality is that he has no prospect of ever paying back the borrowing. All it takes is for one creditor to ask for repayment, and the result will be a loss of confidence in the aristocrat's ability to pay. At that point, when the credit stops, bankruptcy will quickly follow. His income does not cover his expenditure, and without the continuation of lending, he is seen for what he is - a bankrupt who has been living on the success of his forbears.

The collapse of the economy of Iceland will probably be raising questions about the creditworthiness of other Western economies. The UK government in particular is making it very clear that the intention is to increase borrowing, and is therefore declaring that it intends to borrow its way out of trouble. Rather than trying to cut back on spending, it fully intends to pretend that there is no underlying economic problem, with no need for reform. It is business as usual, all the while with income dropping, and borrowing increasing. No explanation is being given for how this increase in borrowing is to be repaid, what source of new wealth is around the corner to allow the repayment of this ever-growing debt. The question this raises is how it is that the rest of the world will continue to lend? At what point will they ask the question of how this debt will ever be repaid?

The fundamental problem is this. As long as the rest of the world keeps lending, there is demand for the Western currencies. As long as this demand continues, it helps to prop up the value of the currencies. This in turn protects the value of the money that is being lent. What happens if the amount of lending decreases is that the demand for the currency will drop, and with it the value of the currencies. The trade balances of the US and UK in particular have been negative for a long time. Put another way, the demand for the $US and £GB is driven by lending, not by demand to buy goods and services. For those that are creditor countries, they face uncomfortable choices. If they cease lending, then the currencies of the West will collapse. If the currencies of the West collapse, they will lose huge amounts of money on the lending they have already made. On the other hand, if they keep lending, they are faced with the problem of how the money will ever be repaid. In crude terms, do they continue to throw good money after bad?

It is for this reason that I have predicted that it will not be long before the lending stops, and that this will lead to government defaults. I can only guess the time scale because, at the end of the day, it requires that the creditors of the West ask the right question - the question of how their money will ever be returned to them. It will also require them to accept the losses on their previous investments, which will be a hard pill to swallow. Finally, they will know that, with the collapse of the Western economies, they will be pulled down with along with the West. For countries like China, with very real prospects of social unrest, they will be balancing the cost of continued lending against the survival of the Chinese Communist Party. Do they continue to finance the Western world's ability to live in comfort, do they continue to lend their hard earned money to prop up a decadent and bloated Western world - for that is how they will see it. They produce, and the West consumes and does not ever pay the bill for the consumption. It is hardly a good deal for them.

So what happens if countries like China decide that enough is enough. It is at this point that the Western governments find that they can no longer pay the bills. At this point they must either print money, or dismantle huge parts of the state. The $US, the Euro and £GB will fall through the floor. The peg to the £US used by the oil states will be dropped, and the cost of oil will soar. Even without printing money, the rate of inflation in the Western economies will soar, and the result will be complete economic chaos. The reality will be that oil will be oversupplied, but the shift in the currencies of the Western world will mean that, for the West it will become relatively very expensive. The same will happen with other commodities. This is the rebalancing of the allocation of commodities that I discussed in previous posts. I spoke of the competition for finite resources between the emerging economies and the Western economies, and that the West would lose out, and find its share of world resources decline. This will be the mechanism by which this decline will be transmitted.

I have not spoken very much about the social and political consequences of what will happen, as this blog is focused on economics. However, at this stage, it is worthwhile discussing this briefly, as there will be a feedback into the economic situation. If I am right that the lending into the West must end, and the result of this end to lending is as I have predicted, then we will all be in for a roller-coaster ride. The shock to the Western world will be dramatic and painful. In these circumstances, it is an ideal environment for demagoguery. It is the moment of the populists and the rabble rousers. There is a real chance of massive social upheavals, and even challenges to democracy and capitalism. In the rest of the world, there will be similar upheavals. The biggest worry is China, which already has a state that already looks like a worrying hybrid of pre-WWII Japan and Germany. There are many flashpoints for conflict, such as Taiwan. With a government with legitimacy built upon economic growth and nationalism, what happens when the economic growth stops? The Economist magazine is optimistic about the prospects for China in this upheaval, and we can only hope that they are right. I have always been very slightly optimistic that China will pull through this period with only moderate damage, but still have many serious reservations.

I mention the political and social dimension for the reason that the result of the next stage of the crisis will lead to a situation of chaos, by which I mean chaos theory (no doubt serious chaos theorists will shoot me down on this usage, but I hope that you will understand my meaning). By this, I mean that even small events or factors may have profound consequences. The right person being in the right place at the right time, a decision of bureaucrat, a rumour - all of these offer opportunities for dramatic changes in the situation. In other words, there will be a period of huge instability, and that instability creates opportunities for small events to have profound consequences.

As you may gather, I am profoundly worried by the current situation. I was able to predict this crisis, but was not able to predict the way in which governments would react. The way they have reacted is a way that will ensure that the crisis leads to economic disaster. In choosing to try to borrow their way out of trouble, in failing to reform their economies to lower costs and prepare the way for real wealth creation, they have sent a message to their creditors. That message is that they must continue paying for the comfort of the Western lifestyle, at the cost to their own people, or they must face the consequence of massive economic upheaval, and consequent chaos. I believe that creditor governments will be trying to work through this question, trying to see how this can all end. I can not be the only person raising these questions. At some point in time, the complete lack of logic in the current situation must come to an end. There is no way that the creditors to the West can be happy to be supporting the Western economies, with little prospect of ever gaining any return. At some point, it just must come to an end.

I am sorry for such a gloomy post, but my aim has always been to try to analyse situations in as realistic way as possible. For new readers, there are many points in here that require deeper explanation, such as the role of commodity supply in the world economy. You may want to take a look here to understand why the situation is as I say it is. You may also want to take a look at the other posts that I link to at the top left side of the blog. This all may sound like an extreme take on the situation, but there is a disturbing logic in this analysis to be found throughout this blog. Even as I write this, it is a sunny day, and the world outside appears normal and unchanged. The best way to understand how deceptive this calm might be is to imagine the tourists sunbathing on the beaches of Phuket, just before the Tsunami struck. In a matter of minutes, their world was turned upside down.

Note 1:

Ishmael asked the following question:

'My question was in regards to the system of fractional reserve banking and the criticisms that have been made in a few documentaries especially "money as debt" and "zeitgeist" and "zeitgeist addendum"

This article can explain the debate better than I.
http://en.wikipedia.org/wiki/Criticism_of_fractional-reserve_banking

I was wondering on your opinion on this matter as my financial knowledge is a little basic, Is a crash inevitable or is there another mechanism at play that mitigates the effect of exponential debt plus interest?'

I have not seen either of these documentaries, but I do discuss fractional reserve banking and my post on the subject can be found here. It is a rather unusual perspective, but if you stick with it, I hope that you will find it interesting. My article on government borrowing and interest rates may be of interest as well.

Note 2: An anonymous poster has mentioned how easy it is to make fake coins, in reference to my cynicism about the Amero conspiracy theories. Thanks, for the contribution, which is helpful.

Note 3: I have the following from an anonymous poster (edited):

'I know the idea is to get the banks and mortgage providers lending again, but they cannot go back to lending to people who will never be able to repay the loan.(sub prime)

With the economy about to take a dive, (and I suspect never to recover to pre crash levels) what sort of an economy will follow?

The only exponential growth in the Western world is people, Britain (and America's) populations are rocketing and it is my guess this is where the growth is to be conjured, as I suspect it has for the past eleven years. '

The answer to this is relatively simple and also terribly complex. The one certainty is that the economy of Western countries will be considerably smaller. As to what kind of economy, that is the complex question. Increasingly socialised, protectionist, or lean and mean and ready to face the competition in the world? That, to a large extent, is in the hands of the politicians and where democracy is in play, that is in part in the hands of each individual with a vote. Will the voters look to the state to 'fix' the problems through protection, endless state interventions, or will they decide that they want to regain their place in the world? This ceases to be a question of economics, but becomes a question of politics.

Note 4: A very late reply to Phil (apologies)

I’d like to offer a further point of reflection: while in the West we continue the “Debt Economy Delusion”, what the biggest producer of real wealth - China - will do?
12 October, BBC News website had an article, “China agrees land reform package”.
The article quotes Xinhua news agency:
"The Communist Party of China Central Committee on Sunday approved a decision on major issues concerning rural reform and development," Xinhua said.
Its commentary added: "The global credit crisis freezing up the world's finances may be a blessing in disguise for China as it aims to modify its economic structure after three decades of breakneck growth."
My take is that, as the global crisis will restrict external demand for Chinese goods, China will expand its internal market, the biggest single market of the world.
And what will happen then, monetary speaking? Will the Yuan increase its (now artificially lowered) value?
And, as we are at it, what will happen to major world currencies?

This is a very interesting comment. The RMB will certainly have to significantly increase in value, at some stage or another. I tried to keep my own money in RMB for that reason, but holding money in China is problematic. There are many possible drivers for a large upward revaluation, including threats of protectionism, and it is difficult to say when the CCP will allow a major revaluation. Add into this mix the questions about internal stability, and what might happen if China falls into recession, and life gets more complicated.

One of the interesting things about an artificially low currency is that drives economic growth through export led growth, but at the cost of the relative wealth of all the individuals in that country. To give an example, a Gucci bag may be significantly more expensive than it otherwise might be with a balanced exchange rate. That differential means that, in real terms, the potential purchaser of that bad in China is poorer. In short, the people in the country do not get a 'fair' price for the imports that they buy. If you look at it this way, China could overnight become significantly more wealthy, just by revaluation. However, in doing so, could they maintain their economic growth? It is not certain at the moment that this is, in any event, possible. It really is a very complex point. How much of China's success is due to the artificial currency rate? I am not sure on this, but think that it is significant a factor. However, the cost of this approach is now coming at them through the back door, through the damage that the undervaluation has helped create (unbalancing the world economy).

As you can see, a very involved answer, and one that illustrates the inter-connectedness of the world economy. I think I have already answered the questions on currencies in the main post, so will not answer that question further.

Note 5: Another anonymous poster asked this:

This whole business has led to a potential cataclysmic political sea change.

Is neo Liberalism dead in the water?

The ramifications to the answer to this question is mind boggling.

If the answer is yes - What next?

I have answered one of the questions in the main post. Neo liberalism dead? Another one for the politicians, I believe.

Note 6: Hilly asks the following:

'Is the extent and volume of the losses incurred internationally (100s of billions of $) simply due to this over-lending, over-valueing, over-selling etc.. not just in housing (which does incur the losses) but in the levels of borrowings bothprivate & commercial that are being defaulted currently or are anticipated to be so, plus governmental overspending of future incomes?'

I am not sure I grasp your underlying question here, but if you can clarify it, I will try to answer it (time allowing).

Note 7: In reply to a question below:

It's just occurred to me. (I'm not the sharpest tool in the shed) Are we, (West) in the absurd position of being lent money by China to enable us to buy their goods?

It's a sort of merry-go-round that could continue for ever.

This is something I have discussed previously in this blog. You are absolutely right, except about the ability for this to go on forever. The lending will only go on as long as the lending creates a return. As soon as the returns diminish, the merry-go-round stops. It was an unsustainable economid model and part of what we are seeing is the collapse of this model. It was not just China, but all of the creditor nations who have funded the West to buy their products. It sounds mad when you think about it, but this is why I make the Aristocrat analogy. Think of the situation where the aristrocrat buying his tailoring on credit.

Note 7: More questions (see below). I only have a little time so I will just answer a couple of those raised (all too briefly). Answers are in italics.

'The economic backdrop to the 21st. century is the mantra of ever increasing growth in a world of diminishing supplies of raw materials. (is this the same as your commodities?) The production of raw materials (commodities) relative to demand are decreasing even though output in absolute terms has increased. See post here.

Where has all the money gone? Has it been consumed on trips to Disneyland, McMansions, SUV's, snowmobiles, second homes, etc.etc. The short answer here is yes. Much of the money has gone into consumption, and therefore has been spending now at the cost of foregoing future wealth.

With the present arrangement of China having become the workshop of the world, they have amassed shed-loads of dollars amounting to hundreds of billions, what are they supposed to do with this mountain of money? Not hundred of billions but fast heading towards $2 trillion. That is one of the problems that they face (and other creditors are facing). The West is not producing enough of what they want to buy at a price they are willing to pay. That means that the value of the currency must devalue. Once it is no longer used to fund Western borrowing, then there is no demand for the currency, and the value of the currency falls.

The only thing they can do with it is lend it back to the West or buy up Western assets as investments. Yes, see above. But they will no longer want to lend it, as their little prospect of the ability of the West to repay. We are not making enough goods that they want etc. (see above answers). This is one of the points in the above post, so I think I will need to rewrite it, to better explain this.

With the World's dwindling resources I cannot see manufacturing returning to the West, which again prompts the question, where is the wealth generation to come from? Please do not buy peak oil and the rest of the scare stories out there. oil must peak at some point, but there is no firm uncontested evidence that resources are dwindling, and peak oil has been predicted since the 1930s. It could be now, or it could be later. I was posting months ago that oil would drop to $60 when the peak oil believers were predicting $200. Last time I checked it was at $75. Overall demand has outstripped the ability for suppliers to meet the demand, but demand is now falling back as the Western economies contract. Again, see post here. The main problem is bottlenecks, not the amount of material (a curious example is the inability to produce the huge tyres for the monster trucks used in open mining)

As an aside, how can the West (Britain) embark on an economy of manufacturing when the have just announced another round of cuts on carbon emissions? Expect 101 ways for this to be quietly abandoned in the coming years. I think that you will find hard times will diminish the enthusiasm for action which damages economic prospects.

Naive question perhaps, what is the difference between borrowing money and the government printing its own? In other words why borrow when you can print it? This one is not a short answer, so I will (time allowing), try to address is another time. The simplest answer...Both options are bad, but printing money is worse.Not a naive question, but a very good one deserving a proper reply.

I am afraid that time has run out (explaining the rushed responses above). I will try to put more time to answering questions but must balance my limited time against the general posts. As such I will do my best to keep answering as many comments as possible.