The King Canute Economy

I have had a good day in browsing through the economic news, as I found three very interesting articles which together represent a consistent theme (although I say lucky, I mean only in the finding but not the implications of the content). The first of these comes from Ambrose Evans-Pritchard, the second Peter Schiff, and the last Liam Halligan. For the former, Ambrose Evans-Pritchard, I often disagree with his analysis, but can not dispute that he often identifies some fascinating stories on the economy. Today, I came across an article which is of particular interest, and some highlights are given below:

In a report entitled "Worst-case debt scenario", the bank's [Societe Generale] asset team said state rescue packages over the last year have merely transferred private liabilities onto sagging sovereign shoulders, creating a fresh set of problems. [this was exactly my argument at the time the first bailouts were being undertaken]

[and]

Governments have already shot their fiscal bolts. Even without fresh spending, public debt would explode within two years to 105pc of GDP in the UK, 125pc in the US and the eurozone, and 270pc in Japan. Worldwide state debt would reach $45 trillion, up two-and-a-half times in a decade.

[and]

Inflating debt away might be seen by some governments as a lesser of evils.

If so, gold would go "up, and up, and up" as the only safe haven from fiat paper money. Private debt is also crippling. Even if the US savings rate stabilises at 7pc, and all of it is used to pay down debt, it will still take nine years for households to reduce debt/income ratios to the safe levels of the 1980s

I strongly recommend reading the article in full. All in all, this is not far from the kind of scenario that has long been painted on this blog. Shifting debt from the private sector onto the public sector, at exactly the time that the public sector would be starved for revenues, was always going to be a disaster.

In another article Peter Schiff, a long term bear, touches on another theme of this blog - the role of China in the world economy, and the artificial low level of the RMB in relation to the $US. The SocGen report and Schiff's report are actually just looking at two sides of the same equation. If we put the two reports side by side, it is apparent that both of the reports are actually discussing exactly the same problem - which is that governments have sought to replace private debt with government debt, and that the only route out of the debt is eventual currency devaluation. In replacing private debt with public debt, the imbalances in the world economy will be maintained. This is an extract from Schiff's article:

While the peg certainly is responsible for much of the world's problems, its abandonment would cause severe hardship in the United States. In fact, for the U.S., de-pegging would cause the economic equivalent of cardiac arrest. Our economy is currently on life support provided by an endless flow of debt financing from China. These purchases are the means by which China maintains the relative value of its currency against the dollar. As the dollar comes under even more downward pressure, China's purchases must increase to keep the renminbi from rising. By maintaining the peg, China enables our politicians and citizens to continue spending more than they have and avoiding the hard choices necessary to restore our long-term economic health.

[and]

As demand falls for both dollars and Treasuries, prices and interest rates in the United States will rise. Rising rates will restrict the flow of credit that is currently financing government and consumer spending. This change will finally force a long overdue decline in borrowing. So, not only will Americans lose access to the consumer credit that funds their current spending, but the things they buy will also get more expensive.

Our short-term loss will be in sharp contrast to the gain felt by foreigners, who will be rewarded with falling consumer prices and a more abundant supply of investment capital. In other words, the American standard of living will fall while that of our trading partners will rise.

As for Liam Halligan's article, he reports on a report from the OECD as follows:

Less prominent was the admission that: "The upturn in the major non-OECD countries, especially in Asia and particularly in China, is now a well-established source of strength for the more feeble OECD recovery". So the Western world is relying on the emerging markets – the far-flung economies of the East – to pull them out of this slump.

The West's debt-soaked consumers, firms and governments badly need to "de-leverage" – which channels resources into interest and repayment costs, rather than expansion. The likes of Brazil, China, India and the others, meanwhile, have far, far lower debts than their Western rivals, so can spend the next few years "levering-up" – taking on more credit, in turn fuelling growth even more.

All of these articles relate to and article I wrote a long time, explaining the underlying change in the world economy, and which explained the economic crisis as the shift in wealth generation from West to East. In particular, the opening of the East saw a sudden massive expansion of the labour force (labour meaning with access to capital, markets and technology).

My argument was that the massive credit and housing bubbles were simply masking the underlying change in the world economy that flowed from the supply shock of new labour into the world economy. I have written several versions of the article, but my version on Huliq is a short version and can be found here (note: there is an error - zero sum 'gain' should be 'game'), or a fuller discussion can be found here.

What we are seeing in the reports and the analysis of the three articles cited here, is the process of governments seeking to hold back and resist the fundamental change that has taken place. The change that I am referring to is that there is a massive redistribution of wealth, and that there is now a situation of hyper competition throughout the world. In an article for Trade and Forfaiting Review magazine, I explain this in simple terms by making a comparison between the fortunes of SUV car manufacturers and the Tata Nano car:

While the US and, to a lesser extent, Europe are seeing catastrophic contractions in their car markets, the Tata Nano has a massive waiting list among Indian car buyers, keen to upgrade from two wheels to four. The contrast between the old industry, perhaps best exemplified by General Motors, and this innovative upstart illustrates the new shape of the real-world economy.

The important point about the Tata Nano is that it is meeting a new demand from a rising middle class in emerging economies. In the interim, the credit-fuelled demand for SUVs, the mainstay of US car industry profits (until recently), is collapsing. On the one side there is a car that rests upon an unsustainable credit-fuelled consumption boom, a car that flattered the aspirations of the indebted and, on the other, there is a car that meets the rising aspirations of the world’s new wealth generators.

The point is that SUVs represent a concentration of car-owning wealth in the hands of the few, and the Nano is the shift of that car-owning wealth into the hands of the many. It is representative of the underlying shift in real wealth, which is redistributing towards the East, and levelling down the West in the process.

It is a crude characterisation of the change in the world economy, but many large companies such as GE are already changing their product lines to meet these changes. The middle of the market has shifted down whilst broadening. The problem is that these changes are real, and are taking place now. Governments are seeking to withstand the reality of the changed circumstances of the world. The trouble is that, as much as any government might resist the change, it is unstoppable. Nobody is going to put the 100s of millions of new workers back in a box - and there are still large reserves of labour ready to enter the market.

It is only when the economy is seen in this light that we can truly see the madness of government policies - whether the policy of China, the US or the UK. Each country is seeking to maintain an equlibrium that never actually existed. The credit and housing bubbles in the West flattered the underlying condition of economies such as the UK and US, and the world economy was misdirected to feed the illusion of wealth in the West. The overall structure of the underlying economy is the Tata Nano economy, but all governments are seeking to maintain the SUV economy. In doing so, the imbalances are becoming ever larger, as ever more is owed by the current account deficit countries to the surplus countries. The growth in the imbalances is simply going to make the final adjustment ever harder.

I call this the 'King Canute Economy'.

In the legend of King Canute on the sea shore, it is popularly represented that King Canute was so arrogant that he actually sought to hold back the tides. However, King Canute was actually demonstrating that, for all his power, there were some forces which he could not overcome. As we contemplate the actions of governments around the world, it is possible to wonder whether they have ever heard King Canute's story.

In the case of King Canute, he ended up with wet feet. In the case of the world economy, the consequences might not be so mild.

The US Economy: A Brief Review

With so much going on in the world at this moment in time, it is difficult to pick a particular subject about which to write. Having reviewed the state of China many times, I thought it might be time for an overview of the US.

A starting point is to consider the financial system, which raises the first point of interest. I have used the term the 'financial system', but what exactly that might be is a difficult problem of itself. In particular, the government and federal reserve appear to have identified the financial system as being comprised of several major banks, such as Bank of America and Citi. They do not seem to include in their considerations the many medium size banks and financial institutions that are also a large part of the system. As such, when statements are issued which effectively say that they must 'save the financial system', they are referring to the 'too big to fail' financial institutions rather than the whole financial system.

I will not detail the epic bailouts that have already occurred (of which there has already been enough coverage), suffice to say that they are indeed epic, and that the scale of the support is being obscured by the secrecy of the Federal Reserve (see here for total borrowings of depository institutions from the Federal Reserve - a bit shocking). Having done everything humanly possible to prop up the banks, including changing accounting rules to allow them to show illusionary profits, the state of the 'financial system' is still dire. News is leaking of the outcome of the so-called stress tests on the major institutions, and it is not looking very positive. Bank of America is reported as needing to raise an additional $34 billion of capital, and Wells Fargo $15 billion, and rumours suggest that 10 of the 19 banks tested need fresh capital. Whilst some of the other institutions are said to have passed the tests, analysts are pointing out that the tests are themselves flawed:

"The exams are too easy, the banks get to take them home with cheat sheets; and if they don't like their final grade, they can appeal for a better one," said Martin Weiss, president of Weiss Research Inc.

The same article points out that the pessimistic assumptions used by the Federal Reserve are simply not pessimistic enough, and this criticism has been echoed elsewhere. This raises the problem that the health of the banks is built upon assumptions for the state of the wider economy, and that mainstream economists have pretty well consistently underestimated the scale of the economic problems.

Perhaps the most important point to take from the stress tests is that, even with the gargantuan support offered by both the government in the US and the Federal Reserve, the 'financial system' still appears to be on the verge of insolvency. The IMF has suggested that the financial system may still need up to an additional $US 500 billion in order to achieve solvency, a figure which appears to suggest that the stress tests are really not stressful enough. Furthermore, the IMF estimates that losses in US banks might reach $US 2.7 trillion, a figure that is simply beyond comprehension. An even greater figure comes from Nouriel Roubini, as well as a damning evaluation of the banks, as follows:

This would be good news if it were credible. But the International Monetary Fund has just released a study of estimated losses on U.S. loans and securities. It was very bleak -- $2.7 trillion, double the estimated losses of six months ago. Our estimates at RGE Monitor are even higher, at $3.6 trillion, implying that the financial system is currently near insolvency in the aggregate. With the U.S. banks and broker-dealers accounting for more than half these losses there is a huge disconnect between these estimated losses and the regulators' conclusions.

The hope was that the stress tests would be the start of a process that would lead to a cleansing of the financial system. But using a market-based scenario in the stress tests would have given worse results than the adverse scenario chosen by the regulators. For example, the first quarter's unemployment rate of 8.1% is higher than the regulators' "worst case" scenario of 7.9% for this same period. At the rate of job losses in the U.S. today, we will surpass a 10.3% unemployment rate this year -- the stress test's worst possible scenario for 2010.

The stress tests' conclusions are too optimistic about the banks' absolute health, although their relative assessment is more precise, because consistent valuation methods were used. Still, with Thursday's announcement of the results, it shouldn't be a surprise when the usual suspects emerge. We fear that we are back to bailout purgatory, for lack of a better term.

What this all amounts to is a process of smoke and mirrors. In essence, the tests are set up to allow as many banks to pass as possible, and for those that do not pass to need a minimal additional capital infusion. Despite all the bailout money from the TARP, and the massive support of the federal reserve, the changes in accounting rules and so forth...the 'financial system' is still largely insolvent.

There are some suspicions that the Federal Reserve is simply too close to the major financial institutions, and that the ongoing support for zombie banks is a result of a that closeness rather than a wider concern for the health of the economy. In light of the actions of the Fed, it is difficult to dismiss such assertions, raising the question of whether there is a corrupted 'inner circle'. Alternatively, it is quite possible that the Fed really does believe that this is necessary for the wider economy. The problem arises that the endless bailouts make no real sense.

In particular, the situation that now exists is that the bank insolvency is being rescued at a (future) cost to the wider economy. One way or another, the socialised losses of the banks will be paid for by individuals or companies. If we actually think about what the financial system is for, this makes absolutely no sense whatsoever. The purpose of the financial system is surely to provide credit for businesses and consumers through the distribution of savings of other businesses and consumers, and to safeguard their savings and investments. It is not entirely clear how the (indirect) provision of credit to insolvent banks by business and consumers makes any sense. Instead of safeguarding and redistributing savings, the banks are (for want of a better expression) burning the (future) savings and money of consumers and businesses.

The fundamental problem that perhaps allows this, is the indirect and future nature of the policy. For example, if the cost of the bailouts were hypothecated and payable immediately, then how far would the policy have gone?

As I have often emphasised in this blog, any borrowing now represents a future contraction in the economy. If government borrows X to spend on Y today, then either the government, businesses or consumers will have X (+interest) less to spend tomorrow. The standard response is that (at some future point) growth in the economy will help to pay for the borrowing now. This raises the question of when the growth will arrive, and from what source/s?

I recently read a report (sorry, in this case I forget where) that painted a sunny and optimistic outlook for sources of growth from emergent technologies. There can be little doubt that there is significant potential in such growth, but a larger question is whether such growth can reverse the ongoing contraction, and provide broad enough growth to replace the debt based economy. In particular, there is still an ongoing deficit in the balance of trade of goods and services. If you doubt the severity of the situation, you may wish to see the broader current account balance for the US here.

Whilst the deficits in the current account and trade are narrowing, this reflects that the US consumer is reigning in his/her spending, and such a contraction is therefore inevitable. The big question is as to whether this will eventually become a surplus, which is necessary if the US is to start repaying debt. In other words, the US needs to climb the mountain from deficits to surplus, before it can even start to repay debt. In light of the ongoing deficits for such a long period, this is a very tall proposition.

Meanwhile, the pile of consumer credit (i.e. a foregoing of future consumer spending) that is outstanding is quite monstrous, as can be seen in a chart here which shows $US 2500 billion outstanding (I use the Federal Reserve of St. Louis for much of the data in the post), and a chart here showing a rise in personal bankruptcy (albeit from a low base). Meanwhile, the savings rate is climbing from negative territory towards 5%, as individuals have realised that rainy days do indeed come about. The consumer is saving instead of spending, which is healthy in the long term, but means an ongoing contraction in the service economy.

As for a big driver of the credit bubble, the housing market, it continues its relentless decline, albeit that the rate of decline has slowed somewhat. At the same time there are reports of increases in consumer confidence, which are puzzling in light of the record contraction in consumer credit and the ongoing climbs in unemployment exceeding half a million a month (curiously the brief slow down in the pace of unemployment is being seen as a positive sign of recovery). Also, where might the consumer spending come from, if savings are increasing and credit contracting?

For business, manufacturing indexes have been in freefall, corporate tax growth is sharply negative (sorry for the idea of negative growth). Meanwhile investment is down sharply, as can be seen in this report:

Business investment contracted by a record 37.9 per cent, as firms scrapped expansion plans and axed jobs, pulling down overall output. GDP was also hit by a record $103.7bn (£70.2bn) reduction in inventories, or stockpiles of unsold goods – and while that accounted for 2.8 percentage points of the decline, it was hailed as good news by many economists.

I was hoping to provide statistics on bankruptcy, but could only find figures for 2008, which show growth in bankruptcy, albeit from a low baseline. However, there is no doubt that one of the key sectors in the US economy is in deep trouble, and that is the automotive industry. Whilst the government is keeping the industry on life support, it does not bode well for the wider state of the economy.

Bernanke is proposing that as inventories are restored, there will be some kind of recovery in the coming months. Whilst an undershoot on inventory sizes might lead to a brief upswing, it is difficult to see where renewed demand will actually come from, or at least demand that will possibly start to match pre-crisis levels. As for an underlying indicator of business health and confidence, commercial real estate is expected to be the next phase of the melt-down:

Schonberger: What's your outlook for the commercial real estate market?

Kemper: I think commercial real estate has yet to play out in the banking system.

I think that we've played out subprime largely, but I think that the same practices and the same players extended lost credit into the commercial real estate space in the past five years or so, and I think those losses are yet to be realized in the system.

Just as for consumers and businesses, the government has long been on a borrowing binge, with total debt now exceeding $US 11,000,000 million and the curve is (of course) rising rapidly. The Congressional Budget Office is predicting a further growth in debt of about $2 trillion in 2009, busting through the congressional debt ceiling of $US 12 trillion. The scale of the borrowing is simply astounding, and the debt is growing at a time of considerable economic contraction, and just as the baby boomer generation is set to retire. Quite simply, it is difficult to see how such levels of debt can be justified.

The nature of the government / Obama $US 787 billion bailout plan for the economy is such that it has been widely criticised for being highly political, and including various pet projects and so called 'pork barrel'. A typical criticism can be found here and another here:

"The stimulus bill was supposed to be about jobs, jobs and jobs, and it turned into spending, spending and more spending," Boehner said. "And then we've got this budget. ... And the fact is, we've got trillion-dollar deficits in his budget proposal for as far as the eye can see."

The criticism of the bailout appears to divide into two broad camps; those who say it is not enough and is directed into the wrong projects which will also take to long to enact, and those who just consider it wasteful and a burden on future generations. Perhaps the most worrying aspect of the bailout and growth in spending is the massive declines in income for the federal government, which can be seen on a chart here.

There is a more fundamental problem in the government attempts to spend its way out of trouble. Even if Keynesian economic policy is accepted (which is not the case in this blog), the increases in government spending would be difficult to square with Keynesian policy. One of the principles of the policy is to save during the 'good times' and spend during the 'bad times'. As can be seen on the earlier chart on government spending, the government had massively increased spending even before the economic crisis hit. There was also the equivalent of a stimulus in the form of the massive credit bubble that formed, such that the economy was subject to two artificial stimuli before the crisis hit. How spending on top of a credit bubble, and government debt binge might be justified is completely baffling.

In essence, what the massive government spending is seeking to do is return the economy to a level of activity that was itself dependent on the credit bubble and excess government spending. In other words, all the stimuli are aimed at returning the US economy to a position which was of itself inherently unsustainable. Is this a Keynesian stimulus? I think it would be hard to describe it as such.

The real tragedy in all of this is that the Federal Reserve has also chosen to lend support for the economy through quantitative easing (printing money), with this from the FOMC:

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

The Federal Reserve is now embarking on a great experiment in monetary policy, and pumping ever more $US into the world economy. A good way to get a grip on the massive increase in the monetary base that is taking place is to look at the chart here, which gives an excellent sense of the dramatic increases taking place.

An underlying principle of such a policy is that, as soon as the economy tends towards inflation, the expansion in the money supply will be reversed by selling the assets accumulated by the Federal Reserve, and thereby destroying the money. This all sounds fine in principle, but the US government is, for example, already selling huge amounts of treasuries. As such, the Federal Reserve will add to the flood of treasuries already entering the market as soon as it attempts to reverse the money printing policy. There are already rumblings about the extent of the issue of treasuries from China, as well as concerns that the printing of money will inflate away the value of the $US:

“A policy mistake made by some major central bank may bring inflation risks to the whole world,” China’s central bank said in the report today. “As more and more economies are adopting unconventional monetary policies, such as quantitative easing, major currencies’ devaluation risks may rise.”

Chinese Premier Wen Jiabao expressed concern in March that the dollar will weaken, eroding the value of China’s holdings of Treasuries, as the U.S. borrows unprecedented amounts to spend its way out of recession. China’s Treasury holdings climbed 52 percent in 2008 and stood at about $744 billion as of the end of February, according to U.S. government data.

We also have an article in the Financial Times, which suggests that the $US is set for a major fall if China finally loses faith in the currency:

US policy is pushing China towards developing an alternative financial system. For the past two decades its entry into the global economy rested on providing cheap labour to multinationals and pegging the renminbi to the dollar. The dollar peg allowed it to leverage the US financial system for its international needs, while domestic finance re-mained state-controlled to redistribute prosperity from the coast to the interior. This dual approach has worked well. China could have its cake and eat it. Of course, the global credit bubble was what allowed the approach to be effective; its inefficiency was masked by bubble-generated global demand.

China is aware it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects its anxiety over relying on the dollar system. The US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.

The problem might be summarised as follows. The US government is borrowing gargantuan amounts of money at a time when the economy is in freefall, and at a time when the government had already racked up massive debts through spending too much. All the while that the government was racking up debts, consumers and businesses were doing the same. The result of this were massive imbalances in the economy which created an unsustainable boom, with continual current account and trade deficits. Essentially, much of the US economy has been supported by this massive accumulation of deficits.

However, as the consumer deficit spending evaporates with the crash in house prices, the US government and Federal Reserve are acting to reverse the loss of unsustainable consumer spending through massive expansion in money, and even greater fiscal deficits. They are making no serious attempts to reverse the deficits, and have no clear plan for how both the government and wider economy might move from deficit to surplus. The recent 'austerity' being proposed by the Obama administration is quite simply pathetic, and will do nothing for the credibility of fiscal policy:

The effort to turn attention to fiscal austerity follows a three-month period in which Obama signed a $787 billion economic stimulus package and a $410 billion spending bill to complete the 2009 budget. The stimulus package includes funding for flood prevention and wastewater treatment programs Obama now says should be eliminated.

His 1,374-page budget for 2010 includes more than $1.2 trillion in funds that must be appropriated by Congress, including big increases in health care, energy and education. The contrast between the proposed new spending and reductions produced derision from Republican critics.

"It's like taking a teaspoon of water out of a bathtub while you keep the spigot on at full speed, and the bathtub continues to fill up," said Sen. Judd Gregg, R-N.H., who Obama tried earlier this year to nominate as Commerce secretary.

For creditor nations such as China, it must increasingly look like the US is initiating the largest default in history - through the destruction of the value of the debts through inflation.

If we then look at US GDP to gain an overview over recent months, the figures are quite simply dire:

The U.S. economy contracted at a steeper-than-expected pace of 6.1 percent in the first quarter, weighed down by sharp declines in exports and business inventories, according to government data on Wednesday that showed the economy was still deep in recession. [nN28309952]

The figure was weaker than analysts' forecasts of a drop of a 4.9 percent rate, according to a Reuters poll, and it also meant output now has declined for three straight quarters for the first time since 1974-1975. U.S. stock futures trimmed gains but still pointed to a higher open. [ID:nN29390529].

It is also important to understand that GDP is a measure of activity in the economy. As such, the figure is itself misleading as an indicator of economic health. For example, borrowed money creates activity, and this is included in the figures. As such, the GDP fall is taking place despite massive increases in government borrowing, which will have increased activity within the economy.

At the moment it is not hard to find optimistic projections for an economic recovery from many in the mainstream media, as well as from government sources. However, if we look at each sector of the economy, the only possible brightspot is a slight upswing in inventories. The idea that the economy might cease contraction overall is very dubious, although the money printing and fiscal stimulus might give a brief appearance of improvement. The trouble with these activities is that they are endangering the value of the $US, through the massive expansion of debt and the potentially inflationary increase in the issuance of the $US.

I received considerable criticism across the web for my predicted collapse in the $US, in particular for getting the time frame wrong. However, as each week goes by, the strains on the $US just seem to increase. The economy is still in freefall; many banks are still insolvent (whatever the stress tests might suggest), unemployment is rising, saving is rising (less consumer spending), businesses are failing, the housing market is falling, businesses are failing, personal bankruptcy is climbing, government deficits are increasing, GDP is falling, manufacturing is declining, commercial real estate is expected to plunge, record amounts of money are being printed, and overseas creditors are becoming ever more cynical.

Overall, it does not paint a very pretty picture. Somehow, people are still managing to be positive and optimistic about the US economy. This is a bit of a puzzle.


Note 1: An interesting debate followed from the post of Lord Keynes. As ever, he offered a well considered contribution, and this was recognised by many of the commentators. As a personal note, I would like to thank him for his effort and contribution, not just for the post, but for his many comments on my own posts. I would also like to thank the many others who contribute comments, which make this blog a lively destination.

Note 2: A review of the US economy proved to be quite challenging. In some respects, there is just too much information. In such a situation there is the possibility of selective bias. As such, if you feel that you have information that contradicts what I have outlined, please feel free to link to the source. I have also, in some cases chosen sources for convenience, and this is simply a matter of the time that I can put in to each post. If you have better sources, again, please feel free to post links. One of the great aspects of the comments on the blog is that commentators often turn up both interesting sources, and some interesting points of view.

Note 3: I did think about waiting for the stress tests before publishing, but decided that the nature of the tests was such that their only importance was in their impact upon confidence. As such I published sooner rather than later.

Defeat is in the Air......

I recently wrote about a Time magazine article, in which they gave the delusional argument that the financial crisis is over. I do not have a great deal of respect for Time magazine but, in one respect, they may have value; in the capture of the mood in the US. I recently came across an article in the magazine that makes very bleak reading. A quote which sums up the mood is:

No one wishes for hardship. But as we pick through the economic rubble, we may find that our riches have buried our treasures. Money does not buy happiness; Scripture asserts this, research confirms it. Once you reach the median level of income, roughly $50,000 a year, wealth and contentment go their separate ways, and studies find that a millionaire is no more likely to be happy than someone earning one-twentieth as much. Now a third of people polled say they are spending more time with family and friends, and nearly four times as many people say their relations with their kids have gotten better during this crisis than say they have gotten worse.

The underlying mood of the article, and the personal anecdotes that accompany the article, is one of defeat and resignation. Quite simply, the subtext that underlies much of the piece is that of a belief in a decline that is beyond reversal. A similar mood can be found in another article from Anatole Kaletsky in the Times, discussing the dire state of the UK economy. His answer is simply to continue borrowing and hope:

If, on the other hand, the economy remains paralysed for much longer or experiences only a feeble recovery when growth resumes, then it won't matter what tax or spending measures Mr Darling announces: public borrowing will grow like Topsy and, in the end, the Government's only recourse will be to inflate away its debts by ordering the Bank of England to print money without limit.

He later puts a more positive gloss on the situation, but there is no hiding from the paragraph that is quoted above. As one of the great optimists for government interventions, his contemplation of financial Armageddon comes as a profoundly shocking admission of the fragility of the current situation.

With all of the news of great economic events, it may seem curious to focus in on the mood of the US and UK, but I believe that this is something that we should not ignore. Economics is about more than just numbers, but is also about culture, drive, expectations and many other less tangible factors. The mood that is being expressed belies the recent sprinkling of false optimism, and is a mood of defeat and resignation.

Perhaps the most telling part is in the stories of individuals and families that can be found in the Time article. The tone and mood tallies with some of the commentators on the blog. There is a rejection of the striving, the desire to make more money, a diminishing sense of ambition. It is a rejection of wealth and the culture of consumption.

I will leave it for others to determine whether this shift is a good thing, but will instead discuss what this might mean in economic terms. I have spoken before about the working culture in China, which I have seen first hand. I believe I once gave the example of a couple working endless hours in a tiny food stall, and how their basic motivation was to provide a future for their children. Their absolute determination and willingness to sacrifice themselves was quite astonishing.

If this example from China is compared with that of the West, it is apparent that there is an alternative to the consumption culture that is currently being rejected in the West. The couple working on the food stall are not working to buy the latest gadgets, or to buy a new car. They are working and saving, with a view to their future security and providing for their children. Whilst a consumption culture is growing in China, saving and security is still dominant.

This is the challenge that is facing the West, and it is not just in China that such values and ambition hold sway. It is the Asian approach, and it provides a driver for their economic development.

When I started the blog, my aim was to not only comment on the current situation, but was also to encourage a view amongst readers that reform was needed to pull the UK (in particular) back from the precipice over which the country is now starting to fall. To this end, I have written several posts on ideas for reform of UK institutions, and these can be found in the links at the left of the blog. When writing the posts on reform, I always kept in mind the reality of the competition from China and the other emerging economies. As such, I sought to balance the best of the existing UK system with a move to greater individual responsibility.

As I look at the shifting of the mood of the UK, and also the US, I see a shift which is still not accepting the reality of the situation (the need for reform), and still not accepting that we must actually face the new competition in the world. For example, Kaletsky's argues that, whatever happens, government deficits will balloon, with or without further stimuli. The one thing he does not contemplate is the deep reform of the systems and structure of the economy. In his mind, whatever happens, the government will still continue to spend money that it does not have and, if recovery does not come soon, whatever happens the government will print money to the destruction of the economy. Kaletsky is not alone. Ambrose Evans-Pritchard has the following to say of the US:

One thing is clear: Beijing suspects that the US Federal Reserve is engineering a covert default on America's debt by printing money.

Whilst attributing the view to China, it is possible to guess that he too is finally accepting that the massive printing of money to purchase debt is simply a default by stealth. Despite this, no complaint is made, and the reality of the default is simply accepted. In the meantime, China's importance in the world economy grows larger by the day, with this from a Telegraph article:

Nevertheless, China remains the strongest economy among the major nations, with the Organization for Economic Cooperation and Development predicting a 6.3pc expansion this year, compared with a 4pc contraction in the U.S. and a 6.6pc decline in Japan. China is likely to shortly overtake Japan as the world's second-largest economy.

Returning to the article of Ambrose Evans-Pritchard, he talks of the purchase of copper by China, and the possibility of a commodity backed reserve currency. By implication, his article is now suggesting the RMB will be the new reserve currency. On the 2nd of March, I had the following to say:

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.

I went on to say:

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.

You may wish to read the original article, as it was a speculative piece about how China might become the economic power in the world. They seem to be following a similar strategy to that which I guessed/proposed that they would follow. In other words, they are on the path to success.

The point in listing all of these articles is that there is increasingly the smell of defeat in the air. China's growth appears to be an accepted fact, with no attempt to address the rise from the West. For example, the US has now backed down on the issue of the manipulation of the RMB:

President Obama repeatedly accused China of outright currency manipulation during the presidential campaign, and Mr. Geithner echoed that opinion during his confirmation proceedings.

But in a new report to Congress, Mr. Geithner not only refrained from such accusations, but praised China for its economic stimulus program and its move toward a more realistic exchange rate for the yuan.

“China has taken steps to enhance exchange rate flexibility,” Mr. Geithner wrote in a statement accompanying the new report.

In all of this, in the articles I have quoted, in the reality of China's expansion on the world economic stage, there is the smell of defeat. Quite simply, the West has given up.

Both the governments and the people of the US and UK are quietly folding their hands, and abandoning the game to China. All the while the US and UK governments rack up greater and greater debts that they can never hope to repay. There is a resignation to the defeat, alongside a terrible denial of the reality of the situation. There is a belief that somehow it is possible to endlessly conjure wealth from thin air, through more borrowing or the printing press. There is a belief that it is possible for governments to still provide, to still offer salvation, even while they set about the process of destroying the economies that might provide such salvation. There is a denial of the reality of China.

A few months ago, I predicted the collapse of the $US and £GB, and the deadline for my prediction is now very close. It looks like my prediction was premature - I was wrong. However, for those who might point out that I was 'wrong', take a look around you.

Do you really believe that we can emerge from this crisis?

From the recent faux optimism, the maneuvering of China into economic supremacy, the unending bailouts and stimuli being made with borrowed or printed money, the dogmatic spending by governments that refuse to reform, it becomes clear that is impossible that it can go on much longer.

We are defeated, because we have given up on the one thing that might pull us from the crisis. That 'thing' is the willingness to accept reality, to wake up, and to earn our place in the world. Instead, we continue to delude ourselves, continue to think that it will be better one day, but make no effort to change the situation. We have given up on our belief that our own situation is in our own hands, and believe that government can rescue us, that China can rescue us, that the world can rescue us.

Somehow, it will all come right in the end.....

My answer to this view is simple. It will not come right. If the $US and £GB survive another month, or another two, or another three, it does not alter their final trajectory. If we sit in an oasis of calm for the moment, it is only at the cost of a greater disruption - greater catastrophe - later. Yes, it appears possible for reality to be delayed, but economics does not work by magic. One way or another, the root of economic success is about the creation of real wealth - not the faux wealth of printed money and borrowing. Printing money and borrowing may delay, but they do not create the wealth that will change reality, they simply destroy that wealth. They may keep the economy moving for a while, but only at the cost of a more painful halt later.

On that very gloomy note, I will end the post.

Note 1: In light of the fact that I have now (probably) called the collapse of the $US wrongly, I was tempted to list all of the things that I have got right. However, I am not sure that this would not just be about flattering my own vanity, so decided against it. Also, as one of the 'big movers' in the world economy, calling the state of the $US wrongly probably eclipses the points that I have been correct about.

Note 2: Tiberius - I also read the story about Goldman Sachs going after a blogger. Hopefully my blogs are general enough to avoid such troubles, but I hope I would in any case still publish and be damned if the need arose. However, I do not think that I would attract such attention as things stand.

Note 3: I have read a long report on the state of the commodity markets. It is a report that has been lent to me, such that I can not quote it. However, it outlines a period of stagnation in the metals markets. By contrast, if Ambrose Evans-Pritchard is correct, it is quite possible that there will be some shifts in commodity prices in the coming months, and the trajectory will be upwards.

Note 4: I talked recently about the need for oil to be traded in RMB if the RMB was to become a reserve currency. I suggested that a back door for China to start this process might be Venezuelan oil. This from the NY Times:

In February, China’s vice president, Xi Jinping, traveled to Caracas to meet with President Hugo Chávez. The two men announced that a Chinese-backed development fund based here would grow to $12 billion from $6 billion, giving Venezuela access to hard currency while agreeing to increase oil shipments to China to one million barrels a day from a level of about 380,000 barrels.

Mr. Chávez’s government contends the Chinese aid differs from other multilateral loans because it comes without strings attached, like scrutiny of internal finances. But the Chinese fund has generated criticism among his opponents, who view it as an affront to Venezuela’s sovereignty.

“The fund is a swindle to the nation,” said Luis Díaz, a lawmaker who claims that China locked in low prices for the oil Venezuela is using as repayment.

This could be coincidence, but the article also deals with wider expansion of Chinese influence throughout Latin America. From my perspective, it is simply China positioning itself for the the crisis that will emerge with the collapse of the $US.

Note 5: Retail sales in the UK were up, according to a report in the Telegraph. If I remember correctly, it was in my last post that I mentioned that inflationary impacts might be reported in positive terms, giving the example of renewed asset price growth. It is therefore to the credit of the Telegraph that they reported the rise in sales as follows:

Last month was the first time since May that clothing sales rose. Sales were strongest in women's and childrenswear, as shoppers were attracted by the new spring and summer ranges. The value of food sales also rose, partly driven by inflation.

The important point is at the end of the quote; yes, if inflation is increasing then it is quite possible that there will be an increase in sales in monetary terms, but this is not a cause for celebration. Expect to see more examples of inflation feeding into figures.....I hope to write on inflation figures in the near future (events allowing).

Note 5: I have had a message from a commentator that a comment was not published. I am not sure why this was the case. If anyone else has had similar problems, please let me know. I am not sure what I can do, but if I know it is a widespread problem, perhaps I can find out the possible causes. As such, if you could let me know what you 'did' and what went wrong, it would be a great help.

Reflections on the Banking Bailouts

I have been giving some thought to the massive banking bailouts, and I am increasingly concerned about what it going on, and the justifications for the bailouts - the idea that we must 'save the financial system'. The more I think about this, the more curious the expression becomes. In fact, the more I think about it, the more I find the expression to be disturbing. It is being thrown around like confetti by politicians and being repeated by the media. My problem is this. Which financial system are we discussing?

If we actually think about financial systems, the requirements of a 'financial system' are surprisingly simple. Here is what is needed:

1. A unit of exchange which holds its value, and which is widely accepted and trusted (money)
   
2. Institutions where any surplus of money acquired can be safely stored (security of money)
   
3. An institutional structure that allows for individuals to use their surplus of money to fund the activities of others, thereby risking their surplus for a greater amount of money in return at some time/times in the future (investment).
   

Much more could be said on point 3, which is purposefully simplistic. I have kept it that simple, because, however we actually look at the situation, this is pretty well a summary of what is required in a capitalist financial system. If anyone can see any other purpose for the financial system, I would welcome their thoughts.

Returning to the bailouts of the banks, this activity is apparently 'saving the financial system'. My puzzle is this; what is actually being rescued?

Now, before I go any further, I must confess to a very serious error in many of my previous posts. Like many others I have been saying that the government is bailing out the banks, and this is completely wrong. The government is not bailing out the banks, YOU are. I would like to be 100% clear on this. I must emphasise this point because every newspaper article, every columnist, every commentator keeps on talking about the government bailing out the banks, and I have also been guilty of expressing this fallacy.

The reality is that the government only has the value resultant from the efforts of individuals in wealth creation activities as a means to fund the bailouts of the banks. In literal terms, when you go into work today, a considerable part of the value of your labour and efforts are being transferred to the banks. As such, part of the value of your labour is literally being given to the banks. The banks are returning absolutely nothing to you for the value of your labour, and this is why it is a gift. For example, the banks are giving the government shares, but shares in something that is insolvent is giving nothing (see note 2). The government is expropriating a percentage of the value of your labour to give to the banks.

In addition to a part of the value of your labour and efforts today being transferred to the banks, a considerable amount of your future labour is being given to the banks. With every day that passes, the government is literally giving larger and larger amounts of the value of your future labour away, by using that promise of future value to give more money to the banks. This means that, in the future, the value of your labour is no longer all your own, but has been given to others in a binding legal contract. Such has always been the way of government (to expropriate a part of the value of your labour) but now it is doing so in order to give it to the banks.

This is, of itself, a rather disturbing idea. However, as we are now in the business (in the US and UK) of 'quantitative easing' the situation is even more disturbing. For regular readers, apologies for repeating this again, but quantitative easing is unconstrained increases in the supply of money, or money printing. When new money is created, it has no value of itself, but transfers the value from the existing money supply onto the new money, and the new money goes towards government uses. For every newly printed unit of currency, there is a removal of value from every other existing unit of currency. This is a form of taxation and it is a tax on every asset, and every unit of currency held by every individual and organisation. These savings and assets represent the stored value of your past labour. This money is going to be used to support the banks, and will effectively be given to the banks.

What we have is a situation in which part of the value of YOUR labour from the past, present, and future labour is being given to the banks. The banks are offering absolutely nothing in return for the value of your labour that is being transferred to them.

I am hoping that this is now completely clear in your thoughts. The government is not bailing out the banks, your labour - past, present and future - is being given to the banks with absolutely no exchange in return. You are all currently presenting a gift to the banks. The government is telling us all that gifting ever greater parts of the value of your labour is good for us all, and that we should be appreciative of the governments efforts to force us to present these ever increasing gifts to the banks. In this point of view, giving money to the banks is 'good', because we will all benefit from 'saving the financial system'.

It is to be hoped that they have a very, very good reason to be doing this.

At this point we can return to the question of what, exactly, the government might be 'saving', when they say that they are saving the financial system with the value of your labour. It is here that the situation becomes very opaque indeed. If we go back to the first bailouts, the nationalisation of Northern Rock in the UK for example, we were told that it was nationalised to prevent a run on the bank. Later bailouts were being made for exactly the same reasons. In amongst all of the chatter, talks of CDOs, and all of the other complex products that constitute finance, there is a very simple point at the heart of the crisis.

Banks have taken the money from depositors and have 'lost' that money such that they are unable to return either the original deposit or any interest. I will clarify this point, as it is very important. When I say that the banks have lost the money, it conjures up an idea of the money just vanishing.

The money has not vanished, it has been transferred. Money does not vanish, it is transferred from place to place, person to person. It is necessary to remember that the only way that money can be destroyed is by central banks, and the central banks have over the last few years been creating money, not destroying money. There is, of course, the possibility of the destruction of physical bank notes, but I do not think anyone is suggesting that people in Citibank were taking $US and putting a fire under them (though they might as well have done so). As such, the money is not being destroyed, is not vanishing, but is being transferred.

The question is this; where is it being transferred to?

If we think about, for example, the Royal Bank of Scotland (RBS) - it has apparently 'lost' a large amount of money and is therefore insolvent without ongoing gifts from you. It has taken large amounts of deposits from individuals and businesses, and has put that money to work in a very bad way, such that it has lost that money. This means that they have transferred the deposits to others in the expectation of that money being returned with interest, but the person they have transferred it to is unable to return it. This is a loss to the bank, and therefore a loss to the depositors, but we must remember that someone, somewhere was in receipt of that depositor money. It was not destroyed, did not vanish, but was instead transferred.

Let's imagine that the money was used for a person to buy a house. When the individual purchased their new home, RBS provided the finance in the form of a mortgage. When RBS provided the finance, they are transferring some of the money of their depositors to the seller of the house. As such, the money has not vanished, it has been transferred. The former seller now has the money, and will according to their own personal circumstances utilise this money in some way. If we fast forward into the future on this transaction, we can imagine a situation in which the borrower loses his job and stops paying the mortgage, such that RBS is forced to repossess (foreclose for US readers), and sell the property. When they sell the property, after all of their expenses, they do not recover the full value of their original loan, making this a bad investment by RBS. It has just 'lost' some of the depositor's money.

However, as we can see from the above, it has not literally 'lost' the money, it has been transferred. The money is still there, but it is in the hands of the original house owner (assuming he has not spent the money). The money is still there, but the depositors no longer have any claim on the money.

In the case of RBS, it has not only been taking deposits from ordinary people and companies to make investments but has been borrowing on its own account to make investments. We need to careful here, as this borrowing is still based in deposits somewhere. When a bank borrows on the wholesale market, it is borrowing from another bank's depositors, even if indirectly, or through complex instruments. It does not matter how it gets into the hands of RBS, the origin of the money is from the stored value of the labour of individuals, otherwise known as savings.

It is here that we come to the big problem. We know that, one way or another, RBS has taken large sums of money either directly or indirectly from lots of depositors. It has then invested that money very poorly. The money, at every stage, is not literally lost, but it being transferred to somewhere. RBS has committed that it will return money to depositors at a certain rate of interest. They promised to return to the depositors more money than they were given, but no longer even have the full amount of the original deposits which have been transferred somewhere else. When depositors are asking for the return of their money, RBS simply does not have enough money to repay their depositors. This is in part because some of the depositors money is tied up in investments which, if they were sold now, would not return the original sum paid for them, some of the money is tied up in investments that are not immediately accessible, and so forth.

Above all else, their investments have been losing money - but remember that this is not a case of the money vanishing or being destroyed. Someone, somewhere actually has possession of that money.

Here is the important point. None of the money has been destroyed, it has all at some stage been transferred. The question is; where to?

For the moment, I would like to leave this question to one side, and return to what is happening to the money that is being gifted to banks like RBS. We know for a fact that as fast as we are gifting the money to these banks, it is being used for something - such that they are constantly asking the government to arrange that we gift them ever more of the value of our labour. We know where some of that gifting goes. For example, when a person who has deposited their money in RBS goes to a cash machine (ATM), and withdraws £50, that money is available to the depositor because of our gift to the bank. If a UK company writes a cheque for office supplies, then the money will be transferred from RBS to another bank using the gifted money.

However, as we are all aware, ever greater amounts of the value of our labour is being gifted to various banks. When we consider the massive scale of the bailouts, this amount of money is more than can possibly be used for these kinds of day-to-day claims on money deposited with the bank. We are looking at sums of money that are way, way beyond these requirements. However, as fast as we are gifting money, it is disappearing, meaning it is being transferred to somewhere.

The question here is again; where to?

Here is where the situation becomes very disturbing. We now know that, across the Western world (see note 1), that broadly speaking the banks are in a very similar situation. They nearly all seem to require that we gift them lots of the value of our labour. If we are all doing this across the Western world, then we know that we are not transferring the money between Western banks, or at least some of the banks would suddenly become very solvent and have lots of money. This is not happening.

As such, the only answer is that the transfers must be going to non-Western depositors, however that might be indirectly achieved. The question then becomes who, and where?

Whatever has happened, none of the money has been lost, it has been transferred. We are seeing ever greater amounts of the value of our labour being gifted to the banks, but we are not seeing that gift appear within the Western banking system. It is being transferred somewhere else. It is being transferred to our creditors, such as the oil states and China. It is being transferred to repay their lending to us.

It is here that we can start to see the central problem. At this moment in time, our governments are transferring ever larger amounts of money taken from the value of our labour, suggesting that they are doing so in order to protect the 'financial system'. It is at this point that we have to ask which part of the financial system they are actually protecting.

The stereotypical picture that we are offered to justify the protection of the banks is the picture of lines of people outside of the banks trying to gain access to their deposits. We can almost hear the cries of outrage at the idea of the 85 year old lady who loses her life savings in a banking collapse. This is supposed to be the financial system that we are protecting, helping to ensure that the little old lady does not lose her savings.

However, in order to protect that little old ladies' savings (or the deposits of companies or whatever variation of this theme), why has it been necessary for so much to be gifted to the banks? Surely, if there were a bank run, the value of the assets of the bank could have been sold, and the government could then have had the option of using its expropriation of the value of our labour to compensate those who lost deposits. It is here that we can see that something is very wrong in the picture. We know that many of the depositors must be from non-Western countries or the money pouring into the banks would appear somewhere in the Western banking system. They are not just protecting depositors in the country, but all overseas depositors too.

In other words, the value of our labour that is being expropriated by the government and being gifted to the banks is largely being used to pay overseas depositors - the Asian countries, the oil states, not depositors within our own countries. Money is pouring out of the Western world. This is why, when so much money is being dropped into the banks it seems to disappear as fast as it is dropped in. When the banks are announcing losses, they are not actually 'losing' the money, they are transferring the money to a new place. That place is not within the Western world - or someone somewhere would be recovering from the crisis.

The problem is this. What we are actually witnessing is our own insolvency. We are having to service the debts that we owe to all of the creditor countries, and we just do not have the means to service these obligations. As fast as we are gifting the value of our labour to the banks, the banks are then using that gift to repay our external creditors, but it is just not enough. The government is having to expropriate ever greater value of our labour to keep the repayments going.

The next big question in this is to ask whether the value of our labour is actually enough to repay what we collectively owe. We have seen ever greater transfers of money out of our countries, as we now know that that is where the money has been transferred to. Each unit of money transferred out is a promise that we will make a repayment equivalent to x units of our labour value in the future. Money is a means of exchange for goods and services, and provision of goods and services are resultant from labour.

Much of the money that is now being repaid was used to fund consumption. This has come in many forms, consumption by individuals and consumption by government. I have many times repeated that borrowing for consumption now means a future contraction. It has been one of the themes in this blog. The simple fact is that we have been borrowing for consumption, and we are now actually at the point where that consumption is being paid for. With interest. However, as fast as we transfer the money that we owe back to the creditor countries, we are making promises to provide ever more labour, as that is what the money we give promises. The money is a future contract on our labour (even a commodity requires labour for extraction and movement etc.).

The reason why governments are expropriating our labour in such quantity is not to protect domestic depositors, but to protect overseas depositors. The financial system that they are trying to save is a system in which we can maintain our borrowing for consumption, which is not actually the purpose of the financial system at all. Only through the expropriation of ever greater value of our labour can they continue to service the debt, and it is only if they continue to service the debt that we can still continue the system of borrowing to consume. Overall, we are still in the position of borrowing ever more money, and we are now borrowing it in ever greater quantity.

The trouble is that this is just taking us ever deeper into insolvency. We are, with every day that goes by, simply consuming more than we can produce, and the longer this consumption continues, the worse the situation is becoming. I have long argued that we must finally accept that we tighten our belts, and deal with the fact that we are much poorer than we think.

The really terrible part of this is that large sections of the media have actually accepted that the government is bailing out the banks. This is simply not true. What the government is actually doing is very, very rapidly impoverishing us so that we can continue to consume -for a short while longer- more than we can produce. They are doing so by promising and expropriating ever greater amounts of the value of our present, past and future labour.

As I sit here writing this, I can not but help but wonder about whether any of those responsible for these ongoing bailouts have any idea whatsoever of what they are actually doing. They stride around bombastically proclaiming that they are 'saving us', saving the financial system, when the reality is that they are deluding themselves, and every single one of us.

In practical terms, this is what this means; you will be working to pay back the investment made by, for example, a Chinese individual who has deposited their savings in a Chinese bank. Deposits like this is what is currently funding much of the economy. This funding of current spending will, in the end, need to be returned to that depositor with interest. If we take away the cumulative deposits of all of these overseas savers, we are left with a much smaller and poorer economy. The stored value of their labour is quite literally being used by us so that we can consume more than we produce. This is the answer to the cigarette lighter problem I wrote about a long time ago.

How long can we and our governments sustain this process of, on the one hand, spending ever more borrowed money on consumption, and on the other committing ever more of your value of labour into supporting the borrowing and consumption? We are just digging our own hole ever deeper because, unless there is a miracle on the horizon, there is simply no way that we are ever going to produce more than we are consuming. If we keep on borrowing to consume the future contraction will just get ever larger, and ever more devastating.

Yes, if governments can keep on propping up the banks with ever more borrowing to pay off the previous borrowing, this process might, just might, go on a little longer. However, in doing so they just wreak more havoc with the future.

The reality is that our creditors are seeing that this can not be sustained. They are seeing us for what we are. We are like the individual using a credit card to pay off our bank loan and mortgage, and all the while selling our furniture to try to make ends meet. All the while we are doing this, we are still shopping and spending more than we earn. It is madness.......

I have read so much justification for the bailouts. I see it everywhere, in the newspapers, and even in the latest edition of the Economist. They all make it sound so plausible, that the banking system must be saved. What none of them are talking about is that you are gifting your future, present and past wealth so that we can continue to consume now....so that we can pretend that we are the kings of the world for that little bit longer...I very rarely put things so bluntly, but it is pathetic. They are 'saving' the banks in an effort to keep the credit lines open, to convince our creditors that we are not bust.

My answer to the question of what part of the financial system we are saving is quite clear. The financial system that is being saved is the financial system that allows us to consume more than we produce at an ever increasing cost to the future. It is a very different financial system to the one which I detailed at the start of the post. A financial system is not there for us to collectively impoverish ourselves, but that is the financial system we are trying to save.

My answer to the crisis is very simple - better now than later. Let the financial system collapse. It is in any case worthless.


Note 1: I use the Western world very loosely here, and it also includes surplus countries such as Germany. I am therefore being a little too simplistic, but hope I will be forgiven for a compromise to aid the overall clarity.

Note 2: I am a business which is losing money, with greater liabilities than assets. I come to you and say that I will give you a share in my business if you give me a large sum of money. You look at my books, and find that I have assets worth £1000, and liabilities of £2000. I lose £100 a week on operations and my losses are increasing fast. There is no significant forthcoming circumstance I can point to which might indicate a change of this situation. If I give the shares to you, are they actually worth anything? In such a case, the only reason someone might give the sum of money would be if they were mad, or as an act of charity - a gift.

Note 3: I think this post might sound a little odd. I hope it makes sense.

Note 4: I think that I will have to deal with the issue of Fractional Reserve Banking (FRB), which I wanted to avoid for this post. I have already had a comment on the subject, so I think now is the time to deal with it.

I will explain the principle in brief. If lots of people deposit lots of money into a bank, they make an assumption that not everybody will want their money returned at the same time. As such, they are happy to lend out a portion of the money that they get. This means that, if I deposit £100, they feel comfortable to lend a proportion of that money (e.g. keep 20% and lend 80%) in the belief that they can service all of the demands for return of deposits that will actually occur. As such if I deposit £100 they will only keep, for example, £20 available for cash and will then invest the rest. In simple terms, the level of the reserve is set to give a safe margin against an expectation of the maximum demand for return of deposits over x period of time.

A bank run is when everyone starts asking for a return of their deposit at the same time and, because the bank only holds a fraction of the deposits as immediately available to return as cash, they can not return all of the deposits.

However, the system gets a little bit weird when we think of a bank using my £100 deposit to invest it/deposit it with another bank. That bank then has an £80 deposit from the original bank, but only needs to keep £16 in reserve, leaving £64 which they can then lend. If we think about this, my deposit has allowed lending of £80 + £64, which means that they are lending more than I have deposited (£80 is lent from the original bank, and £64 from the second bank). If we add up the two sums of money available for lending, then we appear to have created money. This is the standard picture of FRB, that money is created from nothing, but I will illustrate further.

When I enter into bank A and deposit £100, the bank effectively writes me an IOU for the £100. The bank then takes my money and lends £80 to bank B, who writes an IOU to bank A for £80. That bank then lends £64 to a consumer, who writes an IOU to bank B. Whilst it may appear if we look at it in some respects that we are creating money, as more money has been lent than deposited, I think that this is an exaggeration of what is actually happening. In the end, the amount of credit that reaches the end user of the credit has not expanded in the way that those who are anti-FRB seem to imply. Whilst each bank appears to be creating money, the reality is that the more banks that touch the money, the less money there is available to be lent into the economy outside of the banking system.

If you look at the table such as the one shown in Wikipedia, it is accurate but it is deceptive as each transfer from bank to bank actually diminishes the amount of credit available to end users outside of the banking system. Each time a bank touches the money, the availability of credit outside of the banking system actually reduces. In other words you can increase the money supply within the banking system itself, but the more that my deposit is used for intra-bank loans, the less of my original deposit is available outside of the system.

If we look at my £100 deposit, as soon as Bank A lends it to Bank B, only £64 is available to lend outside of the banking system. On the other hand, if Bank A lends the money directly to a consumer or business, they have £80 to lend.

Now I will freely confess that this appears to go against much of the thinking about FRB, and that there are many very clever people who theorise about this. However, as hard as I look, I can only find a situation in which the more that my deposit is loaned within the banking system, the less money that is available in the economy outside of the banking system. As such, if you take the example given in Wikipedia, it appears that money is being created, but the reality is that available credit outside of the banking system is destroyed.

In this situation, it appears to me that if banks stop lending to each other, then the deposits that are held by the banks will make available more credit external to the banking system. I am more than happy to have somebody correct me on this, as this is just the result of my own thinking on the subject, and maybe I am missing something/ or misunderstanding something. It is one of the few areas in my own thoughts about economics where I have nagging doubts. I only have doubts on the basis that so many people seem to imply that FRB creates money available in the wider economy, but I find that this is not the case. In fact, I find that the more money that is created in the banking system the less the availability of money in the economy.

Perhaps I just have it wrong? Comments welcomed (please note that I am not talking about central banks lending into the banking system here which has a different starting point altogether, and where money and credit can both be created).

The Climax of the Fall is Now in View

I am writing this post with a profound sense of unreality nagging at me. When I first wrote about the UK economy (you may want to read here for a summary of where I started), I was profoundly worried, and could see that we were heading towards a massive economic shock. A little while later the realisation that the UK was effectively bankrupt struck me, followed by the realisation that the US was in the same position.

When I first started writing, I could see no way of avoiding crisis, but could at least see a way to minimise the crisis, and plant the seeds for a future recovery. As the crisis has progressed, I have been horrified at the bank bailouts, more recently horrified at the jump into quasi-Keynesian policy, and even more horrified that quantitative easing has been proposed to finance this lunacy. Such actions, as I have argued over many posts, will serve only to magnify the scale of the economic destruction to levels that I had never imagined were possible. The cure to the disease has been to take a hefty dose of poison.

In the newspapers we can read endless reports about the 'financial crisis', which is of itself a misnomer. This is not a financial crisis, but an economic crisis, of which the banking system failures are just one symptom. Throughout this blog I have kept in mind very simple principles and applied them to the state of the world economy. I realised that the key to all of the problems is that the world had entered a period of hyper-competition. The world had changed, and countries like the UK and US complacently stood still, resting on their laurels, with no real attempt to adapt to the changes in the world.

Instead of adaptation, instead of confronting change, we have seen ever greater attempts to bury the reality that underlies this crisis. The reality is that many of the countries in the West, and I refer in particular to the US and UK, are unfit for the competition. Putting it in both simple and accurate terms - we do not produce enough value of goods and services to support our current lifestyles.

This is not a new situation, but has been developing for a long, long time. All that has happened is that the reality of the situation has been obscured from us through a series of bubbles. The dotcom bubble, the telecoms bubble, the stock market bubble, the housing bubble and the credit bubble. One after another they have come, but the greatest bubble of all will be the final bubble to burst - and it will explode our complacency.

This final bubble is the currency bubble. In the case of the £GB it has been rapidly deflating, but is now set to burst. In the case of the $US, once it starts to deflate, it will pop violently.

Of all the factors that have hid our underlying economic fragility, the currency bubble is probably the most significant. In crude terms, those who have been selling all the commodities, goods and services to us have been lending us the money to buy their output. As a result, they have amassed huge amounts of our currencies, and are now starting to realise that the paper they exchanged for goods has no meaningful underlying value.

Why did it all last as long? Part of the reason is that there was an ongoing demand for the paper, so that it could be used to lend back to us. Part of it was just a false belief in the value of the paper, an illusion.

The illusion was like a magician who, with the clever use of mirrors, manages to hide an elephant on the stage. The elephant that has been hidden is that we just can not compete, do not produce enough of value. In the meantime, the rest of the world looked on in wonder at what appeared to be the miracle of our wealthy economies. We seemed to just keep growing, becoming ever more wealthy, ever more indulged in the luxury of comfortable lives. It all seemed to be inevitable, and it was believed by many that this was our natural state.

This grand illusion meant that the rest of the world looked on in wonder at our wealth and power, and continued to take our worthless paper. In fact, the demand for the paper seemed to grow endlessly, and as the demand increased, so did the issuance of paper from our governments. The result is that more and more of this useless paper has been amassing in the treasuries of our creditors, such that there are now mountains of it.

And here comes the problem. What happens when someone tries to use the paper to buy something from us?

It is here that the light finally shines on the illusion, and reveals the mirrors that hid the elephant from sight. It is at this point in time that the realisation occurs to our creditor that we just do not produce enough for the paper to be exchanged for. To mix metaphors, they can come to the shop, but there is very little on the shelves that they want to buy. Sure, they can rummage around and find a few useful items here and there, but they will be left with a mass of paper still stuffed in their pockets, wondering how it might be used.

The truth is; the paper can not find a use, and it is therefore without value.

When I first started writing on the economic crisis, I saw a window of opportunity. If we could just grasp the reality that we were not competing, that we were not producing enough goods and service to support our lifestyles, we could start to turn the situation around. It was a question of us popping the bubble of our own illusions and seeing the result of our own conjuring. The trouble was that, if we saw the nature of our own conjuring, we would have to face the reality that there was, and is, no magic. It would mean that we would have to accept that all that we had come to expect was no longer going to be delivered. We were much poorer than we imagined. It would mean that we would have to accept reform, changes to our economy that would have made our lives that much less comfortable.

Such a reform might have persuaded our creditors that it might be worth hanging on to our paper. The paper might not have much use now, not much value at this moment in time, but they could at least see the potential for value in the future. It was an opportunity to save ourselves, an opportunity to buy time.

Instead of this, the answer of both the UK and US governments has been to seek to maintain the illusion, even as the lights shining on the stage are revealing the mirrors. The lights are brightening and are revealing mirrors everywhere, whether in the bailout of Citibank, the collapse of the financial position of RBS, the rising unemployment, the contraction in what remains of our manufacturing, the collapsing retail and service industries. In amongst all of this collapse, the relentless march of imports continues as a bright light upon our inadequacies.

Above all, the desperate measures of governments shine the brightest light of all. In their increasingly frantic attempts to rescue the illusion, they just serve to highlight to all the nature of the illusion itself. The printing of more paper is like trying to sneak another mirror onto a stage on which the lights are already shining - the illusion is already revealed.

Bit by bit, we are now seeing the result of the loss of belief. The rich are starting to move their money into gold. They are not even holding gold on paper, but holding gold as 'stuff' that can be physically held in their hands. China, one of our former creditors, has pointed that it will direct its sovereign wealth towards emerging markets. Even if we take an example of news today, we can see that the Abu Dhabi sovereign wealth fund are pulling out of a major infrastructure project in the UK:

“The economics of this project should be revisited,” Ziad Tassabehji, the director of innovation and investments for Masdar, said at a renewable energy conference in Abu Dhabi. “We are working with our partners to study the feasibility of the project.”

The economics of the project should be revisited. In that telling phrase, we can see the end. All across the world, as I predicted would happen, our creditors are 'revisiting the economics' and they want no more of our paper.

It is at this point that the bubble starts to burst. The demand for the paper was what maintained the value of the paper. When the demand disappears, the paper becomes useless, as the question arises as to what that paper might be used for. There are already mountains of it in circulation, and nobody wants any more. At just this moment in time, the governments are issuing ever more paper.....

So now we come to the crunch. We have been living on the labour of others by exchanging useless paper for goods and services. What are we going to use for those imports now? If nobody want to exchange their goods and services for our paper, what can we do? It is here that we come to the real problem.

Not only do we have too little to exchange for those goods and services, there is also a huge stock of paper in relation to the goods and services available for exchange. As those that hold the paper realise that the paper has little value, they will seek to exchange the paper as quickly as possible, before the illusion is fully revealed. They will try to exchange the paper whilst is still appears to have real value.

The trouble is that, as soon as one creditor starts everybody else will follow in a mad rush to unload the paper. More and more of the paper will be dumped ever more quickly into the market, and the faster it is dumped, the lower the value of the paper will fall. In this situation there will be ever more paper made available to chase a limited supply of goods and services.

Welcome to currency collapse and hyper-inflation.

As the currencies collapse, the goods and services that are imported will shoot up in price. These are the goods and services which we have been exchanging for worthless paper - goods and services that we have been obtaining for very little in return. It is this massive importation of the effectively subsidised labour of others that will suddenly disappear. We will be left, in practical terms, with the fruits of our own labour and will find how little fruit that labour produces.

All the while this is happening, governments will fall into crisis, and be faced with a situation spiralling relentlessly down. Their revenues will be collapsing, their expenditures escalating, but with no overseas credit available to rescue them from crisis. All the while the bills need to be paid. The military, the police, the health services, the unemployment benefits, the wages of the civil servants, the pensions and so it goes on. How will they pay for all of these people, all of these services?

For years they have been paying for all of this with borrowing. Even in the 'good times' they could not afford to pay the costs of government. In a situation of greater expenses, less revenue, and the clamour for ever more bailouts, how can they possibly pay for all of this?

The answer is the printing press. They will have no choice but to print money, and another accelerator of hyper-inflation will kick in.

I think that the path is now set, and there is no climbing off the path. All that remains now is the question of the 'push', of what will start this collapse. In an article here, Eric deCarbonnel thinks that China will precipitate the crash. I hesitate to summarise the article, which offers a sophisticated and plausible case. However, my scenario (and it is no more than that) is as follows:

One possibility is that Ireland may be the first to fall, as they are in deep, deep trouble. There is already one prominent commentator talking of default on debt, and the prospect of a rash of defaults across Southern Europe. Although this is just one commentator, there are solid reasons for why Ireland is so vulnerable, in particular a very nasty variant of the credit bubble. Alternatively, confidence in the UK economy is leeching away at an accelerating pace. The EU commissioner's report on the UK is just one of increasingly pessimistic forecasts for the prospects of the UK. On top of this, the UK government continues to stretch itself ever thinner, seeks to prop up ever larger sections of the economy, and all to no avail. All the time that is going on, the words risk will be flashing in the minds of the UK's creditors.

I have had one commentator suggest that the US will be the first to fall, and the commentator presents a convincing argument. However, I would argue that the illusion of the US is the most deeply ingrained, and therefore the hardest to shatter. There is even the factor of a 'good will' and optimism bounce of Barack Obama's new presidency as a potential pause for breath. What I am saying is that the economic fundamentals are only part of the equation, as we are also dealing in belief.

From my point of view, it will be the collapse of the UK economy that will be needed to shatter the belief in the US economy, and will be the final impetus to push the $US over the edge. Such a collapse might even see a brief run to safety into the $US, before the realisation hits that it is a run into danger.

However, this is just thinking of orders of collapse, and such scenarios are about emotional reaction and belief, as much as they are about economics. Such reactions are difficult to predict, and there is always the influence of events, such as badly worded official statement or any other small trigger. In the current situation, small events have potential for major outcomes.

Whatever the final push, I now believe that we are on the edge and, as such, I will brave a timescale. I would now say with considerable confidence that we are within three months of the plunge. By plunge, I mean the serious collapse in either the $US or the £GB, either of which will shortly after precipitate the collapse of the other. I am not tempted to say how far they will fall, but it will be a dramatic fall over a period of about two weeks, sufficient that we will all look on in complete shock. I am not talking about 10% but tens of percent. Once the sell-off starts, I am not sure where it will stop.

I have always been a 'doomster', and taken a negative view on the prospects for anything but deep, deep crisis. To date, the events that have occurred have largely agreed with such a pessimistic outlook. In this case I sincerely hope that I am wrong, and that I will be eating these words in three months time. My worry is that this will not be the case.....