Economic Crisis - As Expected Government Finance in Tatters

It has been a while since I last posted, for which I must apologise. I have just been looking through the news, and it is apparent that UK government finance is sinking fast. Regular readers of this blog will know that I have long been predicting a government default, as a result of creditors losing confidence in the UK government, and that I have been tracking the steady erosion of confidence. Even the most optimistic investor will be looking at the latest government figures and will be wondering whether the UK government can sustain payments. In particular, it does not take much imagination to see that the UK economy has not even begun to reach a low point, even if you believe mainstream economists.

In other words, although potential creditors to the government do not yet realise how bad the UK economy will get, they will still realise it has a long way to fall. Perhaps in response to the emerging loss of confidence the government has admitted that taxes will have to rise in the future to pay for the borrowing now, which is a politically painful thing for the government to say, but necessary as a measure to keep creditors on board. The final point of note is that the Yen is strengthening, as the carry trade is now unwinding. It appears that one of the sources of finance in the West is evaporating. For those that are unaware of what the carry trade is, the article explains this, but the important point is that one of the sources of the wall of money that fuelled the credit boom, the service economy and government debt is disappearing. The effect will be less finance available to the West, as well as further downward pressure on Western currencies.

Another piece of news is that inflation is now plummeting, in part on the back of plunging prices in the shops as a result of deep discounting. The result of such discounting appears to be that retail sales have only fallen by a small amount (0.4%), presumably as shoppers think they are being offered bargains. By contrast, retail sales in the US are in a dire state, and it can only be a matter of time before the UK follows suit.

The plunge in inflation was also something that I predicted many months ago, and the I predicted that the driver for the plunge would be the discounting of shops that would be desperate to keep sales in the face of loss of consumer confidence, as well as falling oil prices. Oil prices are now around $50 per barrel, with my original prediction at $60, and a later prediction suggesting that $50 was possible. The fall in oil prices is the best indication of how much trouble there is in the world economy, as the drop in demand for oil is an excellent indicator of the drop in economic activity overall. In my guesstimation for inflation I balanced the factor of retail discounting against the fact that the £GB would be falling, making imports (including oil) more expensive, and concluded that the balance would not be inflationary. It is, however, a fine line, and continued deflationary pressure will in part be determined by how far the £GB falls.

Perhaps one of the interesting points in all of this is that the 'bargains' available in UK shops is probably what is supporting retail sales at the moment. One of the drivers behind my thinking on the UK and Western economies was the experience of living in China. If you are able to speak Chinese, and know China well, it is apparent how overpriced just about everything is in the West. The best illustration of this is the habitual overpricing Westerners are faced with in China, as the Chinese know that they can offer a very high price, and that 'dumb' Western people will still think they are getting a bargain. We are so used to paying outrageous prices for everything, we simply have no idea of how cheap things can be when they go through the supply chain of a low cost economy.

On a completely different subject, I have been watching the saga of the 'Big Three' US motor manufacturers unfold. I found an excellent article on the subject in the New York Times, which I recommend that you read. It is, of itself, an excellent lesson in the importance of manufacturing as the base of real wealth creation. The author looks at the numbers of jobs that would be lost with loss of these manufacturing giants, and it is somewhere in the region of 2.5-3 million. The author quite rightly makes the point that the foreign owned manufacturers within the US would, in part, take up some of the slack, but how much remains a question of debate. The important point here is that the manufacturing industries support a raft of other economic activity throughout the economy.

Whilst many economists have imagined a dreamy scenario in which the West designs and sells products, with high waged workers doing all the design and management, this does not, and never has been anything but a dream. Even were this sunny scenario to be true, how many of this high earning jobs would be needed to support the less well educated workers in productive activity? How many such high paid jobs could ever be supported? The madness of these dreams is part of what has allowed so many to believe that the 'service economy' was sustainable. I have argued before that this was in any case a dream, as the service jobs would anyway follow manufacturing. I gave the example of a product designer. If the designer does not understand the manufacturing processes intimately, then how can they design well. In other words, how will a designer in the West be able to compete with a designer in China, who is cheaper, increasingly as well trained, and has the 'on the ground' experience of the manufacturing processes. As I said, it was always a dream.

The last point is that I have read a commentary in the Telegraph in which they mention that the government is going to 'force' banks to lend. Again, this is much as I predicted would happen, and one of the many reasons why the bailout of the banks is just going to get ever more expensive. What this means is the government is going to force the banks to make very high risk loans, and will sow the seeds for an ongoing bad debt problem for the banks. Any notion that the government will ever make a profit on their banking bailout was always going to meet the problems of political interference in commercial decisions.....

As you may have noticed, there is no particular theme to this post. If I was to pick any theme at all, it is apparent that the dream world that the West has been living in is evaporating before our eyes, but the politicians and public still believe in the dream. With every day that goes by, more news of reality impinges upon their dreams, but still the politicians, and it seems large sections of the public, are turning their faces from reality and comforting themselves with the dream. Even as the UK government pushes the UK economy into destruction, the public appear to be increasingly backing the government in this action. I think that the only thing which will finally shatter the dream is the coming default of the UK government. It is no longer a question of if, but when....

Note 1: A note for Death to Bubble Addicts - Thank you for your invitation, which I will accept when I have time. I have not published your message, as I do not know whether you intended it for publication.

Note 2: I have just found an article on the problems in Ireland. It seems that I may be wrong in thinking that the UK government will be the first to fall into default. It seems that Ireland may be about to reach the finishing post first:

Michael Klawitter, a strategist at Dresdner Kleinwort, said the cost of insuring Irish sovereign debt through credit default swaps (CDS) has surged to 133 basis points. "The markets have begun to see a risk to the solvency of the Irish government. They are questioning whether it has the financial muscle to back up the guarantees," he said.

The problem it seems, is that the Irish guarantee of the Irish banking system is breaking the government's financial position. This is what I have said would happen with the UK bailout (though it is not the only factor, just one of many), but it seems that Ireland is going to be the first to be pulled down. If Ireland does go down, it is a further impetus to the loss of creditor confidence in the UK, and when the UK goes down, the US will follow. Call it economic dominoes if you wish.

UK Government Edges Ever Closer to Bankruptcy

First of all, my apologies for not posting for a while. I have been, and still am, tied up with a lot of work in my 'real life'. As such, yet another hurried post.

I was finally compelled to post again when I saw an article in the Times. The article deals with storm clouds gathering over UK government funding. For readers from the US, this may deal with the UK, but is just as relevant for the US. I have argued previously that the fall of the UK government into bankruptcy will be the trigger for the loss of confidence in the US. I believe that the collapse of another major Western economy, will finally puncture the illusion of the wealth of the West. I will quote the article at some length:

'Growing concerns in global markets over how Britain will fund the surge in government borrowing triggered by the recession are piling more pressure on the weak pound.'

And,

Worries are surfacing over the threat of a vicious downward spiral in which waning appetite among overseas investors for UK assets, including government bonds, or gilts, saps the pound's strength. That, in turn, makes it still less attractive to take further holdings in assets denominated in a depreciating currency.

As well as aggravating the plunge in the pound, the trends could add to problems for the Treasury in raising the tens of billions of extra borrowing needed in coming years as the cost of recession and bailing out banks send the Government deep into the red.

And,

Although these outflows may be fuelled by fretful investors simply bringing funds home, Simon Derrick, Bank of New York Mellon's head of currency research, said that the data pointed to a fundamental shift, and heightened wariness over both UK investments and the pound.

And,

However, he sounds a warning that a global glut of cheap capital that made it easy for the Government to borrow until now is drying up, while Britain will have to compete for funding with governments that are also planning to borrow much more.

I have, for a long time, been pointing out that the UK is structurally bankrupt. Back in July I wrote the following:

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

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

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

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

As a note, since that post, I have pointed out that the IMF may not be an option, on the basis of the question; who will be funding the IMF?

As the government sought to 'fix' the crisis through the banking bailout, and then chose to spend its way out of recession, it became ever more apparent that the overseas investors, who have been financing the defecit, would gag on such proligacy. I explained the nature of the problem in a previous post at the start of September, and will also quote this at some length:

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

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

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

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

Once again, it appears that I am in the unhappy position of being correct. I say unhappy, because I still keep hoping that I will be proven wrong. However, the likelihood of that happening appears to be diminishing. The recent news that the government is seeking to stimulate the economy with tax cuts (or buy off voters?) is just another nail in the coffin of government financing.

In another post I identified that one of the major car manufacturers in the US woul fall, making the following post:

The first is that the bailout is just a continuation of the delusion that the UK and US can continue to borrow their way out of economic reality. The other posts are just a series of illustrations that economic reality will have its way (sorry, I am giving an abstraction intentionality here, but you will know what I mean). The service economy is collapsing, and it will take with it large swathes of the US and UK economy with it. As just one example, it is likely that we will see the collapse of at least one of the major US car manufacturers. The US manufacturers have, even during the good times, been struggling for survival, and now that times are tough, they will be in real trouble. The first reports of serious drops in their sales have started.

I pick on the car industry for good reason. In particular I am thinking of Ford, as this is not just another company, but is symbolic of the past successes of the US economy. It might even be argued that Henry Ford invented the modern world of manufacturing. I highlight this, as the failure of a company like Ford will finally create the shock that will really snap the minds of people in the West into the reality of how bad the situation actually is. It is also an illustration of all that is wrong in the Western economies. Ford, and the other US car manufacturers, have been trying to survive with both hands tied behind their backs. I forget the actual figures, but the US car companies have to load into their cost structure something like $1300 (it may be more, I do not have the Economist article to hand) per car, to pay out on pensions, health care etc. There have been numerous negotiations with unions to try to deal with these problems, numerous compromises. However, the unions have never really accepted the severity of the competition that the companies were facing. In the back of their minds was the belief that the companies could not really fail, they were too big and had been there so long...

The idea that the big companies were in trouble was not something that other commentators were unaware of. At present, General Motors is looking ever more at risk, and the response of Barack Obama has been to back a bailout of the industry:

Nancy Pelosi, the Democrat Speaker of the House of Representatives, and Harry Reid, the Senate Majority Leader, are believed to have sent a letter to Mr Paulson asking him to offer a financial lifeline to General Motors, Ford and Chrysler.

It is believed that Mr Obama is supportive of their request, but it is also understood that he is drawing up his own plans to provide federal assistance to help the American car industry to survive.

This returns to one of my long standing themes. Is it possible for government spending and borrowing to support all of the carnage taking place in the economies of the UK and US. Why the car industry, and not the 'little guy' whose business building house extensions is collapsing? More to the point, in bailing out these failing industries, which by definition are bad businesses, the US government is taking on debt, and that debt will be paid for by the good businesses or consumers. In the case of consumers, it adds a structural cost to doing business, as the higher tax required of consumers will mean that paying a 'living wage' will become more expensive for employers.

Above all, this points to the ongoing foolishness; the belief that the UK and US can just keep on borrowing money forever. In a previous post I discussed who I thought would be the best choice of president, and remained neutral whilst advising that the best choice would be the candidate that who was most likely to face reality. It is apparent that Obama has failed already, as much as that might hurt the feelings of those that saw him as a messianic saviour.

As I have long and consistently argued, the way out of debt is not to load up on more debt, but to cut costs in the economy, and prepare the economy for a return to real wealth generation. In the UK and the US the opposite is happening, and the policies of both countries represent pressing down on the accelerator of debt that will take their governments faster over the cliff of bankruptcy.

Quite simply, it is a tragedy.

Note 1: On a related note, I also predicted back in July (when 'experts' were still predicting $200 per barrel) that within two years oil prices would be back down as low as $60 per barrel. Some time after that I revised my prediction down a little lower to $50 (if I remember correctly). Oil futures are now trading at just under $60 per barrel.

Note 2: Sorry not to respond to the many (very interesting) comments and questions, but time really is short today.

Economic Reality Bites Back!

The crisis has, in many respects, followed the course that I predicted. Economic reality intruded on the fragile (false) restoration of confidence that followed the bailout. In the UK, the economy contracted by 0.5% in the last quarter, which will come as no surprise to regular readers here, and Mervyn King has now warned of a recession. The result was carnage for the £sterling which suffered massive falls. Meanwhile around the world stock markets plunged in a state of panic. From the US there is an endless stream of bad news, an example of which is that General Motors and Chrysler are now heading fast towards bankruptcy, and the once mighty Ford is in deep trouble too. These once unstoppable behemoths are symbolic of the underlying problems that are seeing the Western economies contract. Meanwhile, US house prices continue to slump.....

So far, all of this has played to the script that I have been writing for a long time. However, not all has followed the script. The $US should also be plunging, but instead is strengthening as funds are pulled from investments in emerging economies, seeking 'safety' in the $US and Yen. As the article I have linked to points out, there is outright panic driving such moves. An analogy that might explain this is a person running from an angry bear, only to seek safety in the Bear's cave.....where mother bear and her cubs are waiting, and where father bear will soon return. The result of the flight to illusory safety has rocked the world with for example, Russia at risk of sovereign default. Once again, this is not following my script, but any script can not account for panic and emotion driven decision making. In other words, the world financial system has left rationality behind. As with the return to panic, at some point soon, events must return to the script, as there is an underlying economic reality driving events. An explanation of that reality can be found here.

As if there were not enough problems, OPEC is seeking to reverse the one positive in the crisis, the drop in the price of oil. I predicted a long time ago that oil would fall to $60 per barrel, though not as quickly as has happened. I saw the drop in commodity prices as one of the elements in eventual recovery from the crisis. I have previously described how commodity supply is at the heart of the current world rebalancing (and crisis), and in order for the world economy to return to growth it is necessary to increase supply of commodities. As such, OPEC cuts in production are just the opposite of what is needed.

Another worry is that China is now feeling the pain of the crisis. I have always considered that China is on a knife edge, that it was uncertain how the country would ride out the storm. One of the positives that I identified is that China's huge reserves would allow them to cushion the impact, and the Chinese government has duly announced massive infrastructure spending to ameliorate the impact of the world slump. In other words, the money put away for a rainy day is already being utilised. Whether this will be enough to ensure stability in China remains to be seen, but they are in a position of having significant resource at their disposal, even if the value of that resource is heavily weighted in high risk $US. This reminds me of a comment / question that I received as follows:

Following on from Lemming regarding China stopping lending, surely the consequences for them will be a lot worse if they do suddenly stop? Your link points to an article that indicates that the Chinese authorities are trying to stimulate exports by increasing export tax rebates; surely if the West's economies & currencies collapsed it would make it even more difficult for China to compete in the world markets, as well as destroying their potential markets for an even longer period?

Like a bank lending to a business, I can see that it's in their interest long-term to stop lending so much to the West but surely it would be in their own interest to stop lending gradually, rather than suddenly, so they can recoup at least a portion of their previous lending?

As I have previously discussed, economies such as China which have been financing Western economies have a dilemma. If they stop lending, then the value of their holdings will collapse, along with Western economies. However, they must realise that any continued lending will throw good money after bad. My feeling is that the comment is very sensible, but China will need to utilise the resources at its disposal in the support of its own economy. They are, in effect, between a rock and a hard place. If they divert their surplus to the US and Western economies, they will help avoid a general collapse, but at the risk of a collapse in their own economy. In addition, such a diversion will only delay the onset of the rebalancing of economies. It may be possible that they can balance both internal and external problems, but I am not sure that they have enough resource to manage both. Do they have the will to do so? Recent news suggests that they do, but it is difficult to be sure.

As I have discussed before, at this point in the crisis, it is increasingly the decisions of individuals driving events, and how China acts in the crisis will be driven by a few leaders at the head of the CCP. Perhaps the most telling article in the latest round on the financial crisis is an article on the 43-nation Asia-Europe Meeting, in which the following was said:

Mr Miliband said the meeting had highlighted the significant shift in economic power towards the east but also how interlocked everybody's interests were in tackling "deep imbalances" in the system.

"I don't think it's just the fact that we are meeting in The Great Hall of the People and we listened to the general secretary of the Chinese Communist Party talking about the need to prop up global capital markets that brings home to one that there is this big shift in economic power," he said.

This has been the point at the heart of this blog. World economic power had shifted to the East, and now we are witnessing the global rebalancing. Bailouts, international talks, action plans and all of the rest of activity of Western politicians directed towards saving the Western economies are fighting against this shift. In other words, all of the activity to 'save' the economies is entirely pointless.

As I have long, and consistently argued, the only thing that will save the Western economies is reform that will allow them to compete with the emerging economies. Bailouts, more borrowing, Keynesian boosts to economies will only serve to make the economies more debt laden, and less able to adapt to the economic reality that wealth has moved East. Still, despite this reality, the politicians and economists are scurrying around, scrabbling for solutions, and imagining that there are magic wands that can change reality.

Note for new readers: I strongly recommend that you take a look at the links at the top left hand of the page. These will explain why it is that the world has changed, and why the change has led to this crisis. As far as I know, this is the only place that has a comprehensive explanation of the underlying roots of this crisis that actually explains the question of 'why?' I would expect that, if you read the explanation, you will understand my pessimism. You may want to start here....

Note: I have had a very pleasant comment (see below). However, I would caution readers to read other opinions before making investment decisions. Whilst to date my track record of predicting the economy has been extremely good I am, like anyone, fallible. As such, I would suggest looking at a variety of sources. I am personally very confident that I have understood the situation more clearly than many economists, but my views would be contested by any number of economic 'experts'. I will add this warning to each of the pages in the blog.