The UK: Statistics and Economy

Some time ago, I was complaining about the increasing opacity/difficulty in obtaining information about the UK economy, for example with the previously wonderful National Statistics now completely hopeless. As such, I have to offer a big word of thanks to Dr. Tim Morgan of Tullett Prebon, who has made an excellent database of statistics available here, and would also recommend the database to those who are likewise frustrated with finding basic data from the official sites. In practical terms, it means less time looking for information, and more time looking at what the data might mean. This is what Dr. Morgan has to say:

Finding key data on UK issues such as inflation, the economy, spending, taxation and debt can all too often prove time-consuming and baffling. The Tullett Prebon UK Economic & Fiscal Database is designed to contribute to the quality of the public debate by providing all participants with ready access to objective and consistent data.

As a celebration of so much easily accessible information, I will today overload on statistics, and use the statistics as a foundation for a review of the UK economy. First of all the government finances, commencing with a breakdown of revenues (billions):

There are a couple of points of note here; the first is that after the drop that took place when the economic crisis became visible, revenue has been steadily increasing with VAT revenue growth particularly pronounced. A commentator recently suggested that the deficit growth was due to a collapse in revenue, but we can see that this only explains a small element of the deficit. With regards to collecting revenues, I propose a more open, efficient and transparent system, and a system that will also reduce costs and distortions in behaviour. For example, I propose the abolition of all corporation tax, and a flat income tax. Since writing the post on reform, I have identified some problems with the proposal, but still hold with the principles (I may update the post if I have some time).

Below, we have spending (£billions):

I don't think any reader of this blog will be unaware of the growing problems of financing pensions and health with an ageing population. I have often spoken about the necessity of priority; that the government needs to make some hard choices between where an ultimately limited amount of resource might go. I have also argued that there are ways of cutting the expenditure of government whilst also maintaining provision of services and safety nets. For example, as one of the more controversial suggestions, I propose that welfare becomes an interest free loan with a finite duration and amount. It is a system that would see the welfare share of spending fall, albeit that it would increase government borrowing in the short term. It is a return to the principle of welfare; that it is a safety net. If you look at the links at the top right of the page, you will find solutions to some other areas of spending. I chose the area chart format as they give a good picture of direction of spending and income, but the overview is better represented through a bar chart (billions, at current values):

It does not look very pretty overall. In fact, it look downright ugly. We then have to ask what this is achieving. How is the UK economy really doing? This is unemployment during massive credit expansion:

In this figure, we can see the impact of the boom, and the appearance of the economic crisis is vivid. When looking at the chart, when looking at the fall in unemployment, it needs to be considered in relation to debt, both government (see above) and private:

It is very apparent that debt growth was masking underlying problems in the UK economy. The second chart perhaps is more scary than it should be. We need to remember that the massive increase in aggregate debt took place during a period of high immigration; the massive expansion of borrowing and the activity that it generated had less impact upon unemployment as it also coincided with high immigration levels. This is from the ONS:

And this reflects in the number in employment:

In these charts, we can see that the rapid credit expansion did dent the unemployment statistics as much as would be expected, as the size of the workforce was also increasing, with significant immigration accompanying the credit boom. The really interesting part is to see what all of these people were actually doing:

Perhaps the most notable point in this, is the increasing size of financial intermediation. Although the figures only go to to 2010, we can see the expansion and subsequent contraction of areas that would be associated with a credit boom; wholesale and retail, real estate. Somewhat surprising is that hotel and restaurants did not see greater expansion. Financial intermediation by contrast, has grown and grown, and (at least as far as these figures go) has not yet started to contract, but I believe that this is now taking place from various news stories (and see below). I took a look at the 2007 SIC codes, to get some sense of what the high expansion in 'all other' means, and examples include legal and accounting, management consultancy, scientific research, R&D, Market Research, rental and leasing of machinery, recruitment consultancy, security services, administrative support services etc. In other words, some of these activities might be associated closely with credit expansion, and other not. Manufacturing is notably flat, as are the primary commodity sectors. Although the chart given above is helpful, it does not give an indication of actual employment, and I dug out some figures from ONS, and created the following (key is given underneath):

A = Agriculture, forestry & fishing, B = Mining and Quarrying, C = Manufacturing, D = Electricity, gas, steam & air conditioning supply, E = Water supply, sewerage etc., F = Construction, G = Wholesale, retail, motor trades, H = Transport and Storage, I = Accommodation and food, J = Information and Communication, K = Financial and Insurance, L = Real Estate, M = Professional and Technical Services, N = Admin and Support Services, O = Public admin, defence and compulsory social security, P = Education, Q = Human Health and social work, R = Arts, entertainment and rec, S = All other services.

The stand outs are the decline in manufacturing employment, Construction, Real Estate, and Retail, albeit that there is something of an uptick in the latter. Also notable is that the numbers working for the state appears to be in decline, but we need to consider this against the increase in 'All other' in the earlier chart of GVA and the increase in Professional Services in this chart; it may be that there is displacement going on here..... Another stand out is the increase in Q, Human Health and Social Work, which now seems to be reversing. A real curiosity is the growth in in D & E, which covers utilities; for E this can be explained by the rejuvenation of infrastructure being undertaken by the water companies (as a guess), but the increase in numbers for electricity is more of a puzzle. As discussed earlier, finance and insurance sees the numbers reducing, which is not apparent in the GVA chart. However, whilst this paints a picture of the post economic crisis, more interesting is to look at what has taken place whilst the world economy restructured in response to the entry of the emerging economies into the system, so I have added December 2000 to the chart, with the label of 'Series 6'. I have placed it next to the 2011 figures to make the changes more apparent.

Manufacturing is startling, even though we have long known this to be the case. For construction, there is still have a way to go before reaching pre-boom numbers, and any reversal of credit growth will mean this sector will shrink even further than pre-boom numbers. If we look at retail now in comparison with unsecured debt now and in 2000 (see earlier chart), the picture is mixed. In contrast to the more recent picture, accommodation and food, however, appears to be an area that may have some contraction if credit growth slows, but there is a question of whether people will forgo retail to continue to enjoy these services, which is a different question, and might mean contraction in retail. In other words, how will disposable income be split between these two sectors if credit expansion stops. Real estate activities still seems to over-large in numbers employed, and still has a way to go down. An offset here is that there are reports of inwards investment into UK real estate, with buyers considering the UK a safe haven. In other words, the sector may yet have 'legs', but my guess is that it is unlikely to last too long.

I have already discussed professional services, and the picture here may be seen as supporting the point about displacement (also see N, Admin support, which may be the same question). However, when looking at export figures, these services appear to have grown, so it is hard to make sense of the figures when aggregated. Education (P) is a real standout for growth in employment. It would be interesting to see how much of this growth is in the tertiary sector, which would reflect the government goals of expanding tertiary education, and also the increase in numbers of overseas students. Whether overseas students will continue to want a UK education is a question that is debatable, as questions are being raised about educational quality (beyond the scope of this post). Finally, we come to another huge standout; health (Q). This stands as an exemplar of the hard choices being confronted by government. In simple terms, each additional person employed in the health system is one less person with potential to be employed in underlying wealth generating activity in the wider economy. And the numbers are going to keep on growing as the population ages. Much more could be said on this subject, but I will leave this open for the moment (at risk of comments that point out that it is not as simple point as I make it). 

 We now come to wages. Below are some key figures for wages and inflation:

I have titled the chart 'getting poorer', as this is the picture it paints. You need to consider this in light of the ongoing massive borrow and spend of government, and the dubious activity of printing money. Also, you need to consider that the indices for inflation are questionable, and that even if accepting the indices in principle, the impact upon individual households is variable. If we really want to understand something about the underlying nature of the economy, the devil is in the detail (sorry for the messy chart, but it is readable). I have gone a bit further back than the chart above, and this is because of the fascinating story of consumer durables.

You will note how there was significant deflation in the price of consumer durables, which we can safely say reflects the entry of countries like China into the world economy. We can see the peaks in energy prices, and the fall in the same prices as the economic crisis bit home. And now, we see inflation in energy once again; however, this time, the inflation may yet be offset as the global economy teeters (in part driven by higher energy prices), in part by the adoption of fracking. On the other sideof the coin, so called 'green energy' are a potential driver in the UK towards higher electricity prices. The chart below gives annual electricity bills, and it is apparent that they are growing rapidly. It deserves a post in its own right, but there are considerable problems looming for UK electricity supply, and the real cost of 'green' energy is now becoming apparent in Germany (e.g. see here and here)

Higher energy prices, it should be remembered, impact more upon those with lower incomes, and the same can be said of food prices. Income spent on energy is not spent elsewhere. The final point of note is that consumer durables have now started to climb in price. If  we look at the $US exchange rate, which is the currency of trade, we can see something of the reason (£GB - $US).

Other factors that may also having an impact are rising wages in places like China, and rising energy prices. However, if China does slow significantly, it is quite possible that there will again be deflation in consumer durables; as orders in Chinese factories decline, there may be a period of significant discounting as businesses seek to at least contribute something to their fixed costs. However, the trajectory of the £GB may offset this, and there is ongoing money printing policies in the major economies to muddle any idea of future exchange rates. Competitive devaluation through printing money means that UK money printing effects may be neutralised by other countries printing money. In summary, inflation is very likely to continue, but the degree of future inflation is a very open question. There are simply too many variables that might impact upon inflation in the UK, with UK government and central bank policy simply additional influences.

With regards to house prices, they continue to fall in price in inflation adjusted terms, even if headline prices are relatively stable:

More interesting is the house price to earnings ratio, given below:

By historical standards, they are still high. I must however mention that house prices are, in part, being supported by the inwards investment, as discussed earlier, in particular in London. Nevertheless, the current ratio suggests current prices are not as stable as they may appear. The Economist also proposes that UK real estate is overvalued compared with rental value (26%) and income (17%), suggesting that real declines will continue at some stage.

My final chart of the day is one I will copy from a previous post, covers the balance of trade, and comes from the (from ONS):

As I stated in a recent post, it is a good indicator of the long term sustainability of the standard of living within an economy and, again, it is not a very positive picture. 

So how can we add up all of these piles of charts? The first point I would like to make is that we can, in part, see that the economic crisis did NOT start in 2008, but started much earlier. It has been so easy for commentators to blame the 'financial crisis', as it evades the fact that there were changes taking place earlier, and that these were simply hidden under the cloak of massive extension of credit. The UK entered the 'financial crisis' already in a state of economic crisis. When looking at relatively benign inflation in the face of credit expansion, the impact of ongoing deflation driven by cheap labour and cost structures in emerging economies was not accounted for. The very real inflation in house prices was ignored; apparently that was un-worrisome inflation. When I first looked at the UK economy in any depth, it quickly became apparent that the boom years were built upon foundations of credit expansion, and I worried for the future and proposed that people were poorer than they thought. We can now see people becoming poorer in the decline in real standards of living, and the now steady decline in the value of most people's primary asset.

People are becoming poorer in spite of government borrow and spend, which is at astoundingly high levels. When consumers were unable to 'grow' the economy through more debt accumulation, the government tried to 'grow' the economy through debt. Spending tomorrow's income now is not a way to grow an economy, as it will see a shrinkage of disposable income in the future. As it is, private debt is now in a very slight decline. However, this slight decline is more than offset by the massive increase in government borrowing; but incomes still continue to fall. This only serves to illustrate the depth of the economic crisis that confronts the UK. Even whilst borrowing and spending more in aggregate, people were becoming poorer, and unemployment was rising. The UK has not even started to address the crisis that sits metaphorically in front of its nose. It does not take much imagination to see what might happen if the UK was to seriously try to balance its budget. Those £billions of debt generate a large amount of employment. What it does not do is generate underlying wealth; that wealth is generated in the primary commodity industries, manufacturing and the export of services. 

These sectors are the ones that are either sitting on plateaus or in decline. Sure, a flood of money into UK real estate might help tide the UK over for a little longer, but that is surely just another repeat of a bubble. There are still such temporary sticking plasters to cover the gaping wound in the UK economy. What these do not do is increase the ability of the UK to export goods and services, which allow the UK to trade in the goods and services necessary to sustain current standards of living. Quite simply, the UK is unable to compete well enough in world markets to sustain the current standard of living. In this post, I looked at government expenditure, and it is apparent that some expenditure is subject to upwards pressure; health care and pensions. These two expenditures look set to rise, even as the UK faces ongoing competitive pressures. In real terms, it means labour being taken from potentially wealth creating industries, and either being redirected into health care, or labour becoming inactive in increasing numbers. The ability to compete with such shifts in the labour force is a challenge the UK must face, in addition to facing the fiercer competition in the world. The UK is not, of course, alone in such challenges, but faces them whilst already struggling to compete. 

I keep on discussing this, but it does not do harm to say it again. The so-called 'austerity' of the current government is not austerity, but a luxury; a luxury that cannot be afforded. It is spending borrowed money to avoid confronting the real underlying standard of living in the UK. It is storing up trouble in the face of the challenges of shifts in the labour force, and a less forgiving world economy. So what is to be done?

The answer is to start to question what can, and cannot be afforded. My benefits reform is an example of how a principle might survive intact, whilst seeing reduction in cost. The aim is simple; to allow what was intended as a safety net to return to its original purpose. Real reform, the kind of reform that is increasingly necessary, requires that the shackles of historic legacies be thrown off. The benefits system did not start out as it is now; it evolved over time into what it has become. The same can be said of swathes of policy that comprises the foundation of government expenditure. If you look at the UK's tax code, it is possible to see that the (sometimes) good intentions of government after government has evolved into a sinkhole to drain away productive activity. Instead, the UK has a massive and fundamentally unproductive industry with the sole purpose of managing tax. Can the UK really afford to have so much productive capacity dedicated to what, in the end, is a process of collecting x amount of government revenue?

It is these really fundamental questions that must be asked, and asked of every area of government; what must the government do, how can it do what it must do differently and better, and where are the priorities for what government should do? These are the questions that are still not being addressed. In the meantime, the UK is becoming poorer. I see no change to this in current policy; but rather see the opposite outcome, which is an acceleration of the decline in the standard of living. After all, where is the policy to really address the poor and declining performance of the UK economy?

Note: I hope this is not too 'clunky'; comments welcomed on this and all points of the post. I have covered a lot of ground in this, so please point out any errors you may see.

Note 2: Shortly after publication - I am not sure I have made the best use of the data given - a bit like a kid in a sweetshop gorging without pause. Thoughts / comments welcomed.

Krugman Surprises!

Well, the arch stimulator, the deficit spender in chief, has accepted that there is a limit to government deficits and money printing. This is from Krugman:

So there is a maximum level of debt you can handle. In practice, if it makes sense to say such a thing with regard to a stylized model, at some point lower than the critical level implied by this model the government would decide that default was a better option than hyperinflation.

Krugman is responding to Jamie Galbraith, who appears to believe that money printing and deficit spending can resolve all ills (a regular commentator on the blog appears to hold similar beliefs). I must also add Krugman's caveat to his acceptance that massive deficit spending and money printing might cause hyperinflation:

Now, I’m sure I’m about to get comments and/or responses on other blogs along the lines of “Ha! So now Krugman admits that deficits cause hyperinflation! Peter Schiff roolz” Um, no — in extreme conditions they CAN cause hyperinflation; we’re nowhere near those conditions now. All I’m saying here is that I’m not prepared to go as far as Jamie Galbraith. Deficits can cause a crisis; but that’s no reason to skimp on spending right now.

I highlight this from Krugman, as his analysis is very interesting, and I would recommend reading the article in full. It has a few equations, but is largely user friendly. When you are finished reading, you can come back to this post.

The reason I highlight this is that Krugman accepts the principle of seigniorage, an inflationary taxation, and accepts that (somehow) 'the government must persuade the private sector to release real resources'. However, there is an almighty assumption in the entire article that he is looking at a closed system, one in which the resources are closed. He does not exclude the consideration that the 'private sector' might include overseas provider of resources, but seems to believe that they will accept the seigniorage that those within the country might accept. He also fails to note that, even those within the country indulging in money printing have an option of moving their funds to a currency that is not subject to seigniorage.

Here is the problem for, for example, the United States. About $US 4 trillion of US government debt is held overseas, and the US is reliant on continued overseas provision of 'resource' being funded by overseas creditors. If these creditors believe that seigniorage will result in inflation, a tax on their holdings of $US, they will start to find better investments, unless the interest rate offered exceeds the seigniorage. At present, the US has been benefiting from the safe haven/reserve currency status to offset these fears in troubled times. However, as I have long argued, this can only last so long. This view is now starting to become mainstream. This from HSBC (1):

It’s not hard to see how in six months time we will all say it was obvious that the dollar would eventually fall. The US has a highly indebted economy, the global imbalances needed to unwind as the US needs to export more, and EM countries need to import more. Meanwhile, the Europeans have aired their dirty debt in public and taken some measures to address it, whilst the US has not. By this time everyone would have forgotten about the risk on/ risk off fad just as quickly as Dubai disappeared off our radars. As the US economy slows and others in the world raise rates to fend off inflation the dollar will come under pressure. The euro break up premium is coming out and the next phase in this rotation will be a weaker USD and we very well may have seen the first signs of this – the worm is turning.

In this scenario, of a falling $US, the US is left in the uncomfortable 'Chimerica' system, in which China continues to fund deficits in order to keep their export machine turning. Again, as I have long argued, China will eventually reach a limit, the point at which they will no longer continue to subsidise the US with credit that will never be fully repaid (or paid at all?). This is the real 'resource' that Krugman is discussing. Having a borrower tax you on your lending to the same borrower is not really a very attractive prospect, especially where the tax leaves you lending at real negative interest rates.

Then we come to the creditors within the US economy (see graphic here). Just over 60% of US government debt is held by the Federal Reserve and 'intragovernmental holdings', and a further 6.2% held by state and local governments. We then have the curiosity of the circularity of government taxing other branches of government with seigniorage. All I can say to such an idea is 'Huh?'

Then there are the other domestic holders of US government debt, such as pension funds, mutual funds and so forth. If they are lending money to the US government, they do so in the interests of their own investors. Just as with overseas lenders, they might reasonably expect a positive real return on their investments, and there is no real block to moving their investments into currencies that might offer such a real return, except habit and a fear of greater risks in overseas investments. The point at which fear of domestic risk is enough to overturn fear of overseas risk and habit is a difficult one to pinpoint, but nevertheless there is such a point - it is just a question of where? Volatility in world markets has served to reinforce fears of overseas investment, but expectations for the US economy, and US government policy, are a factor in the volatility. It would not take much for a panic to commence.

To put this into context, China is once again pulling back on investments in treasuries:

China reduced its holdings of U.S. Treasury debt in May as total foreign holdings of government debt posted a slight increase.

China's holdings fell by $32.5 billion to $867.7 billion, the Treasury reported Friday.

There is increasing speculation that the Federal Reserve is about to restart the printing presses, and this will only serve to undermine confidence in the $US, as this means more seigniorage:

The US Federal Reserve has already pumped some $1.2 trillion (£780bn) into the US economy to try to promote recovery.

The continued fall in prices will add to pressure on the central bank to take further unconventional measures to push inflation into positive territory.

These measures may include increasing the money supply via further quantitative easing or intervening in the US government bond markets to hold down long-term interest rates.

In recently released minutes from the Fed's June meeting, policymakers raised the possibility of further action later this year, if the economy slows down further.

For the moment, lets play with the scenario that just overseas creditors stop the purchases of treasuries, and that the 'resources' of these overseas lenders will not be available in the US economy. The first impact will be that the demand for US dollars will fall, and with it the value of the $US. This will, of itself, be an inflationary impetus, as all imported goods, services and commodities will increase in price. The second impact will be that, the resources which were formerly entering the US economy (as a result of overseas credit) will no longer be available within the economy. You then have a situation within the economy of a greater supply of money, and less resources available within the economy.

As an offsetting factor, the supply of credit within the economy may be contracting at the same time, due to a wider reluctance of overseas creditors to provide credit in the US economy, except at interest rates that might offset the devaluation of the $US. However, that reluctance will further fuel inflation by reducing demand for $US for private lending into the US economy (further devaluation), and by increasing the cost of credit more broadly within the economy.

All of this will take place whilst the US economy is working under a burden of the existing debt, meaning that a proportion of internally generated resource will be needed to service the existing overseas debt. Even if the size of the debt is being diminished by inflation, there will still need to be an extraction of that internally generated resource to provide payments for overseas debts, and that will be proportional to the level of inflation. The relationship is this; the more resources going to overseas, the higher the inflation in the economy, the higher the inflation in the economy the less resource will be extracted to overseas. Whichever way it is regarded, it is an inflationary impetus - at least until the debt is repaid.

Now let's add in the private domestic investors in government debt. If they start to worry about achieving such poor returns on government debt, they may overcome their fear of overseas investments. In this case, we have an additional problem of capital flight. US dollars will appear in larger numbers on the currency markets, and further depress the $US, and this will provide a further pressure for devaluation of the $US. Likewise, private investment overseas will appear more attractive, depressing investment in private businesses, which will already be suffering from the withdrawal of the use of overseas resource in the economy, due to the lack of credit being provided to the US government. In other words, there will not be credit available to expand the resource generated within the US economy, and make up for the shortfall of resource that was previously provided from overseas.

The only answer for the government is to print yet more money, which will short term ameliorate the problems, but will medium term just heighten the problems. The problem is that it is only possible to go so far with massive deficits and printing money. The US economy is currently reliant on a combination of habit and fear, the 'safe haven' effect, and the inherently unstable 'Chimerica' system.

Krugman is right that there is a limit. The key point in his analysis is he has accepted something close to my own analysis, that money must relate to the provision of privately provided 'resource'. In other words, he seems to accept one of the key arguments of this blog; which is that abstracting money from real goods and services is delusional. In so doing, he is accepting that, in the long term, currency valuations and wealth must be determined by output within an economy. He simply fails to see that, in a world of mobile capital, that there is no such thing as domestic policy acting in isolation. As long as investors have choice, they will seek the best or safest returns.

Real negative interest rates for investors are the danger for economies indulging in deficit spending and money printing, as investors will only accept these up to a point. Words like 'safe haven' and 'reserve currency' are evaluations, and evaluations might change. I recall some time back, an analyst suggested that the $US was nitroglycerin, and we are seeing the US government packing ever more explosive under their currency. In reality, the $US has been nitroglycerin for a long time. It seems that it has just taken more of the explosive to be added for analysts to realise the dangers. Who knows, perhaps even Krugman might get there?

Note 1:

I have been noting that there has been ever more widespread talk about a Chinese property bubble, and this was something I discussed in July of 2008. I can not find an article that mentions this, but I have recently read about the problem of investors keeping apartments empty, and this reminded me of one of my first commentaries on China. I went back to the original article, and found this:

My essay was focused just on the UK and one of the assumptions was that the UK was going to suffer more than any other economy in the current downturn. I knew that the US was going to hurt, and hurt badly. However, the US economy has greater flexibility than the UK, and I therefore expect the pain to be shorter lived, albeit it will still be very bad indeed. I believed Germany and France would hurt, but not too badly. For Italy, I believe that they will suffer very badly indeed. They no longer have the freedom to use their currency to save their economy, and many of their businesses are facing tough competition from the emerging economies. They lack the flexibility or will to rise to this challenge, and will need a crisis before they can even think of rebuilding their economy.

As for Spain, this country was largely off my radar. I was aware that their economic growth was largely built on construction. However, I did not realise how reliant. I read an article in the Telegraph which suggests that Spain may be a candidate for the hardest hit in the current turmoil. It seems that they have allowed a property and construction bubble to rage out of control, and the popping of the bubble will be catastrophic.

Japan I will leave for one side, as I plan to talk about it more at a later date. I also plan to discuss China at a later date, but will just mention a couple of points for the moment. The first point is that it is quite possible that China has a construction bubble. Whilst I was in China I noted that there were lots of apartment blocks being built, and that it was very popular for these to be purchased by investors. In many cases the investors were leaving the apartments empty (Chinese people like to buy property brand new, once it has been lived in the value falls), and they were holding on to the apartments in an expectation of increases in value. In addition to this there has been a boom in the construction of shopping malls, and I noted that they were already (back in January) starting to exceed demand. If the Chinese economy is pulled back due to world demand for exports dropping, it is likely that such investments will lead to a bust. It is also worth considering the state of the Chinese banks. If they are lending into construction in this way, will there be a repeat of the previous Chinese bad lending problems of a few years ago? What other bad lending is buried in their books?

Set against this is that the finances of the Chinese government are very healthy, as are the levels of savings in China. The real question with China is how much their continued growth is reliant on exports, and how much growth can be sustained within China. I will readily admit that I am not sure on this at all. I am not sure that anyone is. My best guess is that China will also hurt, and hurt badly, with a significant potential for civil unrest as a result.

I was wrong about the US, whose policy has gone in the opposite direction to that which I expected. As for the other points, I think I have mostly been right (but missed Greece entirely). With regards to China, I elaborated in the promised later post (again July, 2008) with the following:

So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before.

However, I should also mention that I expected a $US collapse a long, long time ago, and was absolutely wrong (the optimism expressed in the first post quoted above rapidly dissipated in the face of actual US policy responses). However, the reason I gave for the problems with the $US are exactly the reasons that analysts are now discussing. As for Japan, I struggled for a long time to 'get' Japan, and never delivered on the article. Perhaps some time in the future....as I think I do now have a rough handle on the Japanese economy.


(1) HSBC Global Research, July 2010, Currency Outlook.

The Great Lie

My apologies for the long time since I last posted. I have several three-quarter finished posts sitting waiting to be finished but, in each case, I struggled to find anything new to say, and want to avoid just commenting on 'events'.

I finally came around to writing this, due to a comment from one of the blog readers, who goes under the name of 'Death to Bubble Addicts' and who quoted another blogger (not named, sorry). It was actually a comment that was particularly interesting because it was such a succinct presentation of an argument that is at the heart of the blog. I will quote the relevant sections:

It’s astounding that people can’t grasp the simple concept that wealth (as opposed to money) does not grow on trees. We, individuals and governments, have consumed more than we produced, for a long time, or in simple terms we spent more than we earned. Now we, individuals and governments, must earn more than we spend, for a long time. Yes, that will cause a depression. It can’t be avoided because the consumption has already occurred and payment is due.

[and]

Our previous debt-bubble-fueled-overconsumption will be paid for, either by those who consumed, those who provided the goods, those who provided the credit, or the taxpayers. No matter which group pays, that group will consume less because they are paying for prior consumption. It doesn’t avoid anything if the government stimulates using more borrowed or printed money, just shifts the burden from one group to another. Creating future tax burdens by running large govt deficits just shifts the blame down the road a bit. Creating inflation is a tax on savers, which subsequently reduces their ability to consume. Defaulting on debt will be ruinous to creditors.

I read these two sections, and thought about the ongoing message of this blog, and found myself appalled at the amount of complexity - amongst commentators, economists, policy makers - that is used to hide these simple truths. I will repeat the points, just to make sure we can show how simple they are:

• We have spent more than we have earned, and one day will have to pay back the borrowed money we spent.
• Someone has to pay for the borrowing (unless we default), and those people will, at some point in the future, not have money to spend.
  

Much of the purpose of this blog has been about trying to take to pieces the complexity that is used to hide these simple and self-evident truths. In fact, everything we see in the actions of policy makers and the discussions of most economists, is actually an attempt to hide these basic realities. We can see the complexity in the way that they bury simple ideas under jargon (e.g. quantitative easing = printing money), or dense formulae. There is only one formula that is really important, and that is the one that calculates income vs. expenditure.

One way that the borrowing has been justified by policymakers and commentators has been the use of the word 'investment' and this word was widely used in the UK in particular. It is worth pausing and thinking about the word 'investment'. It seems that many governments have been pouring money into investment for many years. Despite that, income has just fallen, and the income is not enough to cover expenses, such that government needs to borrow more to 'invest'. In fact, it seems that, the more the government invests, the more it seems to need to borrow in the future for further 'investment'.

What kind of 'investment' is this? With this scale of borrowing for 'investment', at some point in the future our income should be going through the stratosphere. However, it seems that all this investment just means that, at some point in time, we will have to pay back ever larger amounts of money, and there is no prospect on the horizon of our income increasing.

Greece has led the way. Their government's position is the likely future position of the major debtor governments across the developed world. When the credit ran dry, they were faced with no choice but to implement austerity measures. They are now moving onto the road to paying back the gargantuan sums that they borrowed to bribe and delude their electorate. Likewise, in Ireland, and Lithuania, a similar story has unfolded.

Even with the stark reality of the consequences of excess government debt is placed in front of us, it still seems that the reality will not apply to us. Greece is different, as it can not become more competitive with a currency devaluation. Apparently, that solves the problems. We can all just devalue our currency, and all will be well with the world. I have read this so many times that I simply despair.

A currency devaluation is not a solution, it is simply an indirect form of impoverishment. It is a form of impoverishment that hurts savers, and creates a wage cut across an economy. If we think of an average person, who has a taste for imported Belgian beer, we can see why this is the case. He drinks ten bottles of the beer per week, at a price of £2 per bottle, thereby spending £20 of his income on Belgian beer. After the devaluation his cost for Belgian beer increases to £2.50 per bottle. This means that his expenditure for identical beer has increased by £5 per week, meaning that, in real terms, he is poorer. If we then think of his savings in Belgian beer terms, he might find that he is even poorer. If we imagine that he has £20,000 in savings, before the devaluation he held the equivalent of 10,000 bottles of Belgian beer. After the devaluation he only holds 8,000 bottles.

In the case of our Belgian beer drinker, he made the error of saving. He gets hurt on the real purchasing power of his wages, and gets hurt for being dumb enough to save money. In reality, a currency devaluation is just a wage cut over the economy, and a wage cut that hurts those who have been prudent enough to save (investors).

Devaluation also hurts the overseas investors who have been foolish enough to have put their money in the economy in which the devaluation takes place. In their case, we can think of their investment again in terms of Belgian beer. As with our domestic saver, they put in the equivalent of 10,000 bottles of Belgian beer, but when they take their money back out, they find it is only worth 8000. Sure, they can buy the same amount of English beer as before, but why should they endure being poorer in Belgian beer terms? They invested in good faith, and find that they are poorer.

Apparently, countries like the UK are 'lucky' that they have the freedom to devalue their currencies. I would suggest that the politicians are lucky that they have the freedom to devalue, as it is a method of cutting wages and paying for their past profligacy without actually having to admit that the fault is theirs. They do not have to face their people and tell them the truth, which is the (partly) case in the Euro countries.

I say 'partly', as even when confronted with reality, they instead blame 'speculators' and the evil money men in the markets. 'Yes', there are some who profit from the plight of countries like Greece, but that is not to say that the problem is their fault. It is only because the politicians spent like drunks that the speculators are in a position to profit. These 'evil' investors need the foolishness of governments, or their speculation will come to nothing. What happens is that cause and effect are rearranged. It is not the strength of the speculator's position that allows them to profit, but the weakness of the government's position. In other words, it is the government that is the cause, and the speculation that is the effect.

The trouble is that many analysts and commentators are apologists for this line from governments. In doing so, they distract from the real source of the problem, which is that governments have acted irresponsibly.

In practical terms it is very simple. As a contributing part of society, a worker pays taxes to pay for the activity of government, including benefits such as health care, social security, policing and so forth. All of these cost money, and the worker contributes a percentage of their taxation to pay for these. If the government provides a percentage of all of these activities through borrowing, then they are in effect subsidising the worker's purchasing power through borrowing. The individual worker has the same benefits, society has the same benefits, but the benefits are being paid in part by borrowing. The problem is that the government claims that it is the government that is borrowing the money, when in reality it is the worker who is borrowing the money.

The government will not have to pay back the money. The worker will. The government has no income except through the taxation system, and that means that the government is not really borrowing money, the worker is. What we are seeing in Greece is that the Greek people are trying to move to the position of paying back their own previous borrowing, which was undertaken in their name by their government.

This is what all of the complexity and dissembling is about. Governments borrowed the money in your name, and pretended that the debt was their own. They lied to you. They pretended that the debt was not yours, but it nevertheless belongs to you. It is not the government's debt, it is your debt. Whilst everyone talks in the abstract about government debt, as if it were something separate from the tax base, it is not something separate. Every penny of borrowing is, at some point in time, going to be paid back by people like you.

Sure, again we will see governments dissemble. They will try all kinds of methods to reallocate the debt, for example pouring high taxation onto corporations, or singling out group 'x' or group 'y'. All of this will be done to hide the fundamental problem, which is that they never should have been borrowing in the first place. If group 'x' or group 'y' are such good causes for higher taxation, why was it they were not taxed so highly before? They could have been taxed before, as there was no reason not to, and the debt would have been avoided. Instead, the government will now paint group 'x' or 'y' as deserving of higher taxation with populist rhetoric. At no point will the government ever explain why group 'x' is so deserving of taxation now, when they apparently were so undeserving of such taxation before.

And the commentators and the general public will eat it all up. The government will carry on as governments do, and the inevitable pain will nevertheless take place. In the end, the point of this post is simple. When the pain does come, do not be distracted. Put the blame where it lies. It lies with the government, and with the apologist commentators and economists who have sought to justify the great lie; that government owns the debt, not the taxpayers.

The Deflation Scare

I have several times in this blog questioned why it is that deflation might be a bad thing, including in my discussion of a new form of money. Having presented my arguments, I thought it might be useful to find out exactly why economists insist that deflation is something to be feared. Having read through some academic literature, I found an excellent paper which clearly shows that the deflation scare is exactly that - a scare.

There is absolutely no evidence that deflation will cause depression. I have therefore written a summary of the paper in question below, which is by Gregor Smith (reference at end). It might be noted that his paper is written in the polite tones of academic discussion, but the message is clear. He divides up his paper into some basic arguments and I will follow the format.

1. Deflation is associated with depression

Smith reviews the study of Atkeson and Kehoe (2004) who considered the empirical evidence for a link between the deflation and depression. He summarises their work by concluding that only ‘for 1929-34 is there a positive relationship between the inflation rate and the output growth rate’ and that ‘excluding 1929-34, there is virtually no link [between deflation and depression], even though there were other periods of deflation, especially under the gold standard’ (p1046).

My comment: The important point here is that there have been many, many deflations in which there has been a growth in output.

2. Unexpected deflations are associated with depression

In a contrast to the work of Atkeson and Kehoe, Smith reviews the work of other researchers have utilised different analytical models which have found a relationship between depression and deflation, for example in Canada 1870-96. However, when models take into account other shocks in the economy, the correlations found appear to be coincidental rather than causal, and such shocks also serve to explain the only correlation found by Atkeson and Kehoe.

My Comment: Again, it appears that that there is no evidence that deflation and depression are connected and as Atkeson and Kehoe identify, there are many examples that directly contradict the idea that deflation and depression are linked.

3. Sticky nominal wages

In his review of the literature, Smith finds some problematic findings on the relationship between wages and deflation, such that each of the studies fails to fully explain the relationship between wages and deflation. For example, he reviews the work of Bordo, Erceg and Evans (2000) which explains wage stickiness for the period of the early 1930s, but fails to explain wages in the slow recovery for the period of monetary growth after 1933. His conclusion is that there is a need for further research if there is to be a meaningful debate on how wages might be determined in deflations. In summary, there is a general lack of research that might present any firm conclusions on the relationship between deflation and wages.

My Comment: It is worth noting that, if wages were to remain static in monetary unit terms during a period of steady deflation, the recipient of the wages would find the purchasing power of their wage increasing. As such, the person would, in real terms, see an increase in their wealth. Even if the person’s wage were to decrease in a period of deflation provided that the decrease is less than the rate of deflation, they would still be seeing an increase in their wealth. Why such outcome might be viewed as problematic is entirely unclear. Actual wages in monetary unit terms are irrelevant without relating them to what they might purchase in terms of goods and services.

4. Debt deflation

Smith identifies Fisher (1933) work as being the key work on debt deflation, whose theory Smith summarises as ‘depressions begin with debt liquidation, leading to deflation and then to bankruptcies, and to a fall in output and employment’ and that there is an association between these events and ‘a nominal fall in interest rates and a rise in real interest rates’ (p1050). Smith then identifies that Fisher is rarely cited in empirical studies, that the majority of studies cover the period of the Great Depression, and that the studies that cite Fisher provide ‘little empirical evidence on the mechanisms Fisher outlined’ (p1051). From this starting point, Smith reviews many studies, and concludes that ‘the historical research does not seem to me to provide much evidence on the debt deflation mechanism in the 1930s’, and that no recent studies are identifying debt deflation in a deflationary environment that might support a ‘spectre’ of deflation hypothesis.

5. Deferred Spending

The idea that deferred spending is a result of deflation is described by Smith as the worst argument made against deflation, noting that the saving from deferred spending will lower the rate of interest and increase investment. Smith is quite right to question the principles of deferred spending, but his questioning might be taken further.

Smith later looks at some modern deflations, such as Hong Kong coming out of the Asian crisis, and finds that there is a correlation in these cases with unemployment. However, in some of the cases that he examines, the deflation appears to be resultant from shocks (i.e. the shock of the Asian crisis itself for Hong Kong and the collapse of property prices, the property and equity melt down in Japan). In two cases, Britain and Canada in the 1920s and 30s, the explanations are less clear, though some of the deflationary episodes followed episodes of high inflation, and other parts of his analysis again cover the Great Depression. Without more detail on the episodes in these countries, with which I am not familiar, I am unable to comment on these.

It should be noted here that he is presenting a very limited number of examples in which there is a correlation between unemployment and deflation, and his conclusion is that, whilst he has found a link between deflation and depression (in the form of unemployment), he can not square this with the other studies. Most importantly, he points out that there are 'different kinds of deflations', meaning that there is no reason to link deflation to depression. His own examples, are therefore not indicative of the idea that deflation will cause a depression, or that deflation must be accompanied by depression. Even Smith, despite a genuine intention to examine deflation from a firmly empirical point of view, appears to have a basic confusion in the cases that he studies. The confusion arises from trying to impose economic theory on to the evidence.

The source of the unemployment in Japan and Kong Kong was, in both cases, the result of unwinding bubbles in which resources were allocated in unsustainable ways. The bubbles in the economies led to the destruction and misallocation of capital, and labour being directed into unsustainable businesses. Unemployment is inevitable. It will take a considerable amount of time for the bubble based businessed to unwind, and further time for retraining and redeployment/retraining of workers who are laid off as a result. It is a simple and logical explanation. Why on earth would deflation result in unemployment? As Smith himself identifies, there is a lack of evidence for this mechanism.

The interesting thing about Smith's work is that it is a review from academia (interestingly including work of Ben Bernanke). As was mentioned at the start, he uses polite academic language, which is the language of polite questioning and requests for further study. Nevertheless, he presents a compelling demolition of the idea that there is any evidence that deflation will lead to depression, or that depression accompanies deflation.

The most important point in the paper by Smith is that it shows that deflation can take place during periods of growth in output, that the deflations associated with depressions are mostly the result of shocks and were not causal. At the moment the world economy is undergoing a shock. That this shock might cause deflation does not make deflation a 'bad thing'. It would simply means that it is associated with a 'bad thing'. However, the scare of deflation has been used to justify the printing of money, low interest rates and the fiscal stimuli.

As I argued in an earlier post, it is not deflation that is a problem, but the move from inflation to deflation, or even high inflation to low inflation. What we are seeing in the stimuli and money printing is an attempt to prevent such an occurance. For any borrowing undertaken at a fixed interest rate before the change, these result in real increases in the burden of debt for the period of the fix. Preventing this problem might be seen as a justification for the policy, but the broader cost of these policies is a risk of hyper-inflation. The scale of the potential problem of the increase in the debt burden has never been spelt out, but it is the only legitimate reason that might be used to justify the deflation scare. More to the point, the transition from high inflation to low inflation has an identical effect upon debt burdens (see notes for further explanation), but we have never heard arguments against moving from high to low inflation. Why is that?

At the moment, the depression is already taking place. That depression might create deflation is not to say that the deflation is itself problematic. When looking at the deflation scare, it is a genuine puzzle that the scare has been allowed to gain so much traction. There is simply no evidence that a deflation would take the economy deeper into depression. Despite this, all over the OECD there is a huge experiment in monetary exansion, and an explosion of debt, with the fight against deflation as one of the explanations for this policy.

It just does not add up.

References:

Atkeson, A. and P. J. Kehoe (2004), "Deflation and depression: is there an empirical link?," American Economic Review, 99-103.

Bordo, M. D., C. J. Erceg, and C. L. Evans (2000), "Money, sticky wages, and the Great Depression," American Economic Review, 1447-63.

Fisher, I. (1933), "The debt-deflation theory of great depressions," Econometrica: Journal of the Econometric Society, 337-57.

Notes

Note1: I have included a previous discussion of deflation from a previous post in the notes below, and have added an additional example that shows that consumers do not defer spending:

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In the following examples, it will be shown that the reality is that people do not delay purchases in the expectation of lower prices.

Example 1 – Fast Moving Consumer Goods

If a shampoo manufacturers were to improve their output by 5% through a manufacturing innovation each year, their output of shampoo would increase, and this would reflect in a decrease in the price of shampoo. In other words, there will be a steady and continued deflation in the price of shampoo. According to the idea that consumers will delay purchases in an environment of deflation, in such a situation, consumers would choose to walk around with greasy hair, never buying shampoo in the expectation of further price decreases. Such a proposition is fatuous.

Example 2 – Hedonic Goods

Over the last few years countries such as the UK have seen the emergence of many discount airlines, such as Easyjet. The emergence of these kinds of airlines, and the increase in competition within the sector, has seen the price of air travel deflating. Much of the utilisation of these airlines has been by consumers using the discount airlines to have cheap foreign holidays, and this can be described as a hedonic good. It is an entirely discretionary expenditure as there is no necessity to go on holiday to another country. Despite the continual deflation, there have been many years of continual expansion in the discount air travel market. The deflation has not prevented consumers from taking flights to go on holiday, but rather has had the opposite effect.

Example 3 – Computers

Personal computers (PCs) are an interesting case, as they have year on year improved performance and year on year seen deflation of actual prices. It is also an example that includes both business purchases and consumer purchases. Despite the ongoing deflation in the prices, the market for PCs has had a long period of explosive growth throughout this deflationary period. It seems that the steady deflation in prices has had no impact through the postponement of purchases.

Example 4 – Special Cases

Remaining with the example of PCs, it is possible to construct a hypothetical example of how consumers might indeed delay their purchase in expectation of deflation. If one of the large computer manufacturers were to announce that they would be introducing a new type of computer in the coming year, and that the computer was to offer twice the performance at half the cost, it is quite likely, assuming their claim were credible, that consumers might delay their purchase of computers in expectation of this future deflation.

Example 5 – Purchasing on Credit

The example of purchases on credit with interest of goods and services suggests that there is a fundamental flaw in the deferred purchase argument; that theorists have misunderstood the psychology of consumers. Purchasing a product on credit at interest is a real increase in the cost that will be paid for the good, whilst saving the money with interest paid is a real decrease in the cost paid for the good. Despite this, many consumers do not defer the purchase, but instead choose to purchase the good at greater cost now, than the cost in the future. Furthermore, in sectors such as computers, the deflation of the good does not prevent purchases utilising credit.

If the thinking of those who argue against deflation is considered, such a deflation is a ‘bad thing’ as consumers withhold their money in expectation of lower prices. If this logic is followed, then the new and more effective design of computer is not a good thing for the economy, as it has created a deflation in the price of computers, and has caused a delay in the purchasing of computers. However, once the computer is introduced, it will make more computing power available to more people. How this might be a ‘bad thing’ is not entirely clear. Everyone who purchases a computer sees their wealth increase, as they are able to enjoy relatively more computing power in relation to their income. They are quite literally wealthier.

Debt and Deflation

There is an argument that suggests that deflation causes problems with the servicing of debt, as the value of the debt sees relative increases through the deflation. This is a scenario that appears to be very plausible, and can be backed by some solid calculations and formulae. However, what is missed in such arguments is that it is not deflation that is problematic, but the move from inflation to deflation. It is not the change in the value of money that is problematic, but the change in inflation/deflation from the original inflation/deflation position from the time of the issuance of the loan.

A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.

If we think of this example and think of a change in the rate of inflation from 5% to 2%, and compare this with a change from 2% inflation to deflation of 1%, we can see that there is the same process taking place. In both cases we are seeing the relative burden of debt in relation to income moving in exactly the same way. In the inflation and deflation environment, interest rates will move to reflect the underlying changes in the value of money, and debt burdens will be locked into repayments that are based upon an out of date criterion.

In other words, it is not inflation or deflation that is problematic, but rather it is the change in inflation/deflation that alters the burden of the debt. As such, any monetary system should aim to achieve either stable inflation or stable deflation.

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Note 2: I am currently trying to convert my concept of a fixed fiat currency system into an academic paper. In doing so, I have given it much more thought, and have challenged many of my own ideas. The result is considerable refinement of the idea, and it appears to be an even stronger system than I first thought. I also worked out that the idea was probably inspired by my study of PWR nuclear reactors many years ago. For those that are interested, the money is represented by the neutrons, and the primary and secondary loops are the economy. The moderating effect is similar, and the control rod position might be the point at which the money supply is fixed. There are, of course, points which do not translate from one system to another, but I hope you can see the similarities.

Inflation, Deflation and Money

The post that follows is a slight change of direction. I started one post (see below) and found the question of money was nagging at me. In particular, there were some interesting comments on the subject of money after my last post.

The first point I would like to consider is output and money. The measure of output is a bit of a tricky problem when looking at an economy. In particular, if the measure is made in currency x then, if there is inflation of currency x, it appears that output is actually increasing by this measure.

If we imagine that factory x produces 100 units a day, and there is £100 available to purchase these units, we have 1 unit = £1. If we increase the supply of money without increasing output, then we will have more money chasing the output but still no more output. This is inflation. If we then record output in £, we will measure an increase in output. However, this is not the whole story....

MattinShanghai, a regular commentator, has raised the issue of inflation and money supply as follows:

You've talked a lot about the dangers of hyperinflation resulting from the uncontrolled printing of money by central governments. I have to admit that I'm quite confused about the whole subject, and reading numerous opinions published both by "experts" and amateurs, does not help. On the one hand, there are voices saying that we are on the road to Wiemar-style hyper inflation. Others say that the destruction of paper wealth in real estate and the stock markets, collapse of the markets for securities which underwrote many of issued loans, bankruptcy of financial institutions etc. have "shrunk" the money supply so much, that no amount of central bank money printing can fill the "black hole" and avert deflation.

I suppose that my natural reaction in the face of this is simply to suspend judgment and adopt a "wait and see" position. But I also do seem to have some fundamental problems with supposedly "uncontroversial" aspects (at least in mainstream economics) of money theory. I wonder if you or any of your readers can enlighten me on the subject and point out where I'm wrong.

Matt goes on to offer a critique of mainstream economic formulae, and highlights the absurdity of the fudge factors in the formulae. I find myself in agreement with his critiques.

I have previously discussed at some length the nature of money. In particular, I have argued that money is what 'we' collectively believe it to be. Although Matt has suggested that he disagrees with me on what money might be, I find that he hits the nail on the head in the following point:

But it gets worse. Take the money supply 'M'. What is it? Is it just the sum of notes and coins in circulation? What about money stored in jars buried in gardens? Does this count? How about credit card limits? Savings accounts? Private debts? Cheques "in the post"? Questions and more questions...

What I have argued is that money is 'money' when we believe it to be money. When a shop accepts a credit card, and a person generates a debt on the card, the shop is accepting the payment as real money. They believe that the credit card will provide them with x number of electronic currency units that they will be able to exchange for goods and services in the future.

If I am a worker, and I am short of cash, I might exchange my labour to mow your lawn at some future point in time in exchange for your buying me a beer. I might write an IOU note, promising that I will, within a week, spend an hour mowing your lawn. In turn, you might transfer that IOU to another person in exchange for some cakes that they have baked, and I will have to mow that person's lawn for one hour instead.

The critical part of these two very different transactions is that they must be based upon a belief that the currency in question will be repaid in goods or services in the future. If I am actually lazy and unreliable, and therefore unlikely to meet my promise of lawn mowing, then it is unlikely that my IOU would get very far as a currency for exchange. Quite simply, people will not believe that they will be paid.

I have previously given another example; the famine currency. If we are in a situation of famine, and there is a limited supply of food still available, then the idea of what money is will shift. If I offer my services to you in return for payment, and I am on the point of starvation, I will want to be paid in food. You might offer me piles of gold bullion but, if that gold bullion can not be exchanged for food, then I will reject that as a currency, and only accept the food. Gold can not buy what I need, and therefore ceases to have meaning as a currency. The same might be said of any medium of exchange that might be offered to me, if it ceases to allow me to buy food.

Money is therefore a matter of perception. In a previous example, I have pointed to the lines outside of Northern Rock. The people in those lines wanted bits of paper with the head of the queen printed on them, not IOUs provided by Northern Rock. Northern Rock held large numbers of IOUs, but individuals refused to believe in them. They no longer believed that the IOUs would do the equivalent of purchasing one hour of lawn mowing.

It is when we see money in these simple terms that the arguments about deflation make sense, but it is also possible to see how they do not finally add up.

Banks have been passing on the savings of people (value of their labour) to provide credit in return for IOUs. Those people who have provided the IOUs have promised to apportion part of their future labour in return for the money. The trouble is that there was so much money pouring into countries like the UK from overseas, that prices of assets such as houses rose. As such, there was a boom in the issuance of IOUs which started to exceed the ability to repay the IOUs, or at least impossible without a significant fall in consumption of those issuing the IOUs.

In real terms, a Japanese worker has provided a car to a UK consumer. The UK consumer has promised to repay the labour of the Japanese labour with an equivalent value of labour. For the moment we will leave aside the difficult question of how labour might be valued. In our lawn mowing example it was a beer for an hour of lawn mowing, but it might equally have been an hour of building a shed. The important part is that there is an expectation that the returned labour will have a value that is worthwhile to the recipient.

The problem that has arisen is that the Japanese labour has been exchanging their labour for IOUs, but the labour in receipt of the IOUs is unwilling to return an equivalent value of goods or services. The credit crisis is simply a recognition of this fact.

In other words, huge amount of the IOUs are no longer recognised as money, or at best are seen as debased money.

At first blush, this appears to support the deflationary argument. It appears that the money supply in the countries that were recipients of the labour of countries like Japan, now have less money. After all, individual IOUs have ceased to be an accepted unit of money. There is a lack of belief that the individuals can repay in an appropriate value of goods or services.

However, instead of issuing credit to individuals, the new method is to extend ever more credit to governments. As such, instead of lots of individual IOUs being generated, there is a single huge IOU being developed as a replacement. Just as with the individual IOUs, there is an implicit promise to return the value of the labour at some future date. In other words, even as one form of money is being destroyed, more money is being created as a replacement. Of even greater concern is that the previous money that was supposed to have been destroyed, has not in fact been destroyed. It is being converted into the new form of money - government IOUs (of course, government debt was expanding even before the credit crisis, but I hope that you understand the point).

Now, if we return to the beer and lawn mowing example, one of the key features of the transaction is that I have consumed the beer. Now if we imagine that I am not just issuing the IOU to you, but making similar deals all around the town, I am getting extremely drunk, and having a very good time this week. However, all the time I am drinking, I am in a situation where I am promising greater and greater amounts of labour to people all over the town. In fact, I am promising that next week I will undertake 100 hours of lawn mowing. In other words, for the consumption of this moment in time, I am going to have to have a very tough week next week. In addition, even if I do all 100 hours of mowing, I will have to use all of that labour for repayment, and will not be able to exchange my labour for beer during that week.

I wake up on Monday morning with an almighty hangover, and can not face the job of the mowing. As you would expect, the creditors of my beer drinking binge are none too happy when I fail to show up for work. The problem they face is that the beer has now been consumed, and there is no way to get it back.

Unlike in the analogy that I have provided, there is another important consideration. In the real world, governments are now borrowing more, and promising to repay the debts that were accumulated during the binge. As a result of this, the creditors are willing to continue to extend credit. The important point about government is that they can, through the taxation system, enforce less consumption upon people, and indirectly force them to work more. In other words, they are in a position where they can allow me to drink more beer now, but make me work the necessary 100 hours next week. It is on this basis that creditors continue to lend.

As such, as the situation exists, there is more money flooding into the economy, and ever more IOUs being issued in return. In other words, the money supply continues to increase, and the form of money is IOUs.

Now if we were just to imagine that Japan was the only creditor, then we can see that we have a growing debt of labour to Japan. That debt translates into a future commitment to provide goods and services of 'x' value to Japan. If we then think of this in practical terms, each gilt (for example) that is issued is a call on the output of the UK economy. If we then see no increase in the output of the economy, we can see a greater amount of labour owed per unit of labour. If each unit of labour is producing one unit, but we keep issuing ever more IOUs against that one unit, then it becomes less and less possible for that labour to service the debt. What you have is more and more IOUs making demands on the one unit of output. That is inflation.

In addition to this, we have the confounding factor of what I would call 'traditional' money. This is the units of £GB, and I call this traditional on the basis that this is what the people who lined up at Northern Rock believed to be money.

As regular readers will be aware, the Bank of England is creating more of this traditional money, but is doing so without any commensurate increase in output from the economy. This means that, in addition to more IOU money being issued, there is more traditional money being issued. This is, in effect, a double whammy. Both the issuance of traditional money and the issuance of IOUs represent a commitment of future labour in return for the credit now. They are both being expanded at a time when the output from labour is not expanding.

The one factor I have not included in the example of the real world is time. In the case of the lawn mowing, I specified 'next week'. As many are aware, government debt is issued over a range of time periods, such that in different periods, different quantities of debt are due for repayment. I have not included time, as there is currently no proposed time frame for government to start repaying the overall burden of debt. Rolling over existing debt, whilst accumulating more debt, means that the time frames are moot points.

The only solution to these problems are as follows:

1. There is a massive reduction in consumption, and an expansion in working hours. This would allow an increase in output available for repayment of debt. This is deemed as politically unacceptable.
   
2. The government takes the credit offered, and later repays it with less value than was implicit in the original bargain. This is the process of inflation, in which the government allows ever more issue of money whilst not demanding that labour reduces consumption and increases hours to the necessary level for repayment. Under these circumstances, more money will be chasing the existing output, such that the value of all UK money is debased. Inflation.
3. The government, by magic, engineers a productivity miracle such that output exceeds the increase in the amount of money.

The current policy is item number two, but with number 3 as the excuse for greater borrowing.

If we think of money in the terms that I have discussed, it becomes apparent that the reality of money is contingent on the belief that it will have a future value in goods or services. In issuing IOUs, governments are increasing the money supply, as they are increasing the promise of future goods and services. The problem that arises is that they are being dishonest, as there is no way that they intend to repay the IOUs in full.

They are like me drinking too much beer, refusing to work the 100 hours I have promised, and only accepting that I will do 39 hours of lawn mowing. Not only do I refuse to do the 100 hours, I also insist that many of the 39 hours I undertake is used to purchase more beer. In other words, I am cheating my creditors. My currency of IOUs is debased, and is inflated.

When I have discussed money on previous occasions it has always been highly contentious. I fully expect that there will be further debate on this post, and will try to find time to address any of the points. In the meantime, I would like to just highlight the key points of the arguments.

1. Money is a belief in anything that is seen as a medium of exchange for the future value of labour (i.e. goods and services). Money is only money so long as people believe that it might be exchanged for goods and services that they need/want.
   
2. The value of money is determined by the total supply of money, measured as a division of labour output divided by the units of money in supply, over time in which the money might be utilised. e.g. the timescale of IOUs is a factor in the value of money, as in the case of the lawn mowing. Time and value is contingent on the amount of money calling upon labour output in a given period.
   

The last point is complex, and I hope it makes sense (I had to re-read it myself and I'm still not certain). However, the principles I am outlining are my best explanation of money, and why there must be inflation.

This leaves the timing of inflation in relation to the two points above. The money supply, according to my understanding of money, is increasing. The question that remains is how that increase might eventually translate into demand for the value of labour, at what time. This is a question that is, quite frankly, beyond me. However, I hope that, from this explanation, it is apparent why inflation might be delayed for some time. My suspicion is that inflation will be prompted through a collapse in belief in UK issued money, rather than a progressive increase in inflation as debt falls due.

Of one thing I am certain. More money is being issued than can be supported by output. Short of a miracle in productivity, I see no prospects for anything other than hyper-inflation.

Below is the original article that I was going to write. Somehow, thinking about the points below led me into the discussion of money. The post below may make more sense in light of the discussion of money.

More Green Shoots.....

There has been yet more talk recently of economic recovery in the UK, and the £GB has strengthened as a result. This is a perfect illustration of the point that I made in my recent TFR article - that any good or bad news will see wild swings in markets.

In this case, the good news has been provided by an economic think tank, the National Institute of Economic and Social Research (NIESR). The Telegraph reports their findings:

The NIESR figures were the latest sign that parts of the economy have been staging a modest recovery, and coincided with data from the Office for National Statistics, which showed that UK manufacturing output increased by 0.2pc in March.

It was slightly better than economists expected and represented the second monthly rise in a row after the ONS revised up March's figure from a fall of 0.1pc to an increase of 0.2pc.

There has long been talk of a restocking of inventory, and it is likely that this is the process in action (assuming the figures are accurate). However, there is something faintly absurd in such figures, and this is illustrated in the following quote:

Meanwhile, governments across the world have seen their budget deficits explode as they seek to cushion their economies from the crisis. In the US and the UK, the fiscal deterioration is especially severe - with deficits this year around 12pc of GDP each and no credible medium term plans for balancing their budgets.

What we have here are two figures that simply do not add up to anything. On the one hand we have an explosion of fiscal deficits to around 12pc of GDP, and on the other hand we have a minuscule uptick in a couple of indices. In other words, the situation is so dire that the monstrous pouring of money by the government is still leaving the economy in a situation where it is barely into positive territory on a couple of indicators. The real question here is to ask what this indicators would be showing if the debt spigot were to shut down.

It is at that point that we would start to see the underlying output of wealth creation, in contrast to debt fuelled activity.

It is a long time since I discussed the essential reality of government borrowing, and borrowing in general. For every £1 of borrowing now for consumption there will be £1 less to be spent on consumption in the future. If I have a credit card and I spend £25 on a meal today, next month I will have £25 less (+ interest) to spend on a meal next month. The only way that this may not be the case is if my earnings in the future outstrip the debt, in which case I might still have £25 to spend on a meal, instead of £25 + my increased earnings. Even in this case, my consumption now is restricting my future consumption.

In the case of government, if they borrow to spend money on a nurse this year, there will in the future be the same amount unavailable for spending in the future. In other words, one nurse now, costs one nurse (+interest) in the future. Again, the same provisos apply as with the credit card debt.

The question that then arises is to ask how earnings might increase such that they outstrip borrowing. The only way that this can happen is if there is significant investment in the productive parts of the economy, such that productivity rises. This applies to directly to the example of personal debt, and indirectly to government debt. As a worker, I need to achieve greater increases in my income if I am to be able to continue to spend at the same level as I am now, and these increases can only be sustained through greater output in my area of work. If not, at some point in the future, my spending must decline. In the case of government, it is possible to continue with the same spending only if I tax more from the economy, but this is replacement of private spending with government spending. This is neutral for the economy overall in terms of total consumption.

This discussion does not consider an ongoing increase in borrowing, which appears to be the current solution. In this case, all that is happening is that there is the build-up of a larger future contraction in consumption.

Within this scenario is a deep problem. If the government and individuals continue to borrow for consumption now, then there is less money available for investment into productive output. If the government borrows £40,000 today to pay for a nurse (figure guessed at for illustration), then there is exactly £40,000 less for investment into future increases in output of new wealth (i.e. there is less money available for investment into business). The situation is, of course, complicated by the problem that finance is global, such that an individual economy might have finance for both consumption and investment, but the problem in aggregate remains accross the world economy. Bearing in mind the explosion in government borrowing accross the OECD this presents a problem.

What we are looking at is a situation in which there must be a significant future increase in output per person, a massive growth in productivity, if there is not to be a future contraction. However, there is no prospect or indication of such a productivity miracle on the horizon. Whilst it is impossible to deny that such a miracle is possible, it currently looks improbable. In the meantime, governments are competing for finite capital that might make such a growth in productivity possible, thereby making it less probable.

Returning to the slight uptick in output reported in the Telegraph, what we are seeing is the fruits of debt fuelled consumption, not increases in output that might be sustained in the medium term. This is a best case scenario, but it is just as likely that there will be a tail off in the output once inventories are rebuilt.

At this point I was going to discuss inflation, and at this point I moved to the other article. The point I was trying to explain is that it is quite possible that inflation will offer the illusion of increased output. I suspect that, it is quite possible we will start to see inflationary effects appearing in the economy, and that these might be mistaken for recovery.

As such, I am increasingly concerned that there will be a relaxation of governments as a result of thinking that they have solved the crisis. The problem is that, instead of solving the crisis, they are simply deepening the crisis.



Note 1: The discussion of the Austrian school proved to be very interesting. I am happy to see that I could find some common ground with Lord Keynes on the point that commodity currencies are as subject to debasement by government as fiat currencies.

One of the interesting points in the discussion was the role of ideology in forming views on economics. Regular readers may have noted that I pick 'n mix from various sources, wherever I see a point of interest. As such, I value the Austrian school's critique of Keynesian solutions, but disagree with their approach on many points. I am endlessly impressed with Adam Smith, but still believe that trade can be a zero sum game and so forth. In other words, I do not subscribe to a particular ideology, and am not bound by any particular school of thought.

Whilst having a libertarian streak, in that I mistrust government, I still see a role for government in many areas, such as healthcare, or ensuring legal frameworks operate fairly. I simply believe that power should, as far as possible, not be concentrated. As such, wherever possible government should be minimised and powers dispersed.

However, I would hope that the balance of my personal approach is best expressed in the articles on reform. I am not sure that the ideas would fit neatly into any ideology.

Note 2: A long post, but I hope that it proves to be interesting.