Governments Should Panic - People are Saving Money

The inspiration for this post is the first article that grabbed by attention today, and it was a real attention grabber. For those who think that this blog is pessimistic, this is Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club quoted in the Telegraph:

My concern is that people don't fully understand the dangers lurking out there. The Bank of England needs to move towards quantitative easing immediately – you don't have to wait until you get to zero per cent interest rates. If someone is choking to death you don't think twice about giving them an emergency tracheotomy. There may be dangers, yes, but the alternative is that they die.

These are indeed dramatic words. The interesting point here is that the ITEM club uses the same forecasting model as the UK treasury. As such, the government will be seeing the same flashing warning lights. I have visited the ITEM club website to get more detail on their report, but nothing has been published yet. However, there are several points that stick out in the article, and it is these that have grabbed my attention. In my last post, I was considering the problem with mainstream economics, and the report on the ITEM club thinking relates to this.

The following is apparently one of the great concerns for the ITEM club:

We are now in danger of seeing the economy choke: and once you get into a situation where people are hoarding as much cash as you can throw at them and interest rates are stuck at zero, you're in real, real trouble.

The reason why I looked for a report on their website was to try to clarify their concerns expressed here. It is not clear whether their concern is the interest rates or consumer spending, or a combination of the two.

However, I will proceed with my best interpretation. The interpretation I am using is that their concern arises that people are not spending despite interest rates offering no real return on their money. Bearing in mind that their concern is deflation, they seem to be imagining that people are 'hoarding' cash in the expectation that prices will drop further in the future. In making such a statement, I have a feeling that they are imagining the mythical 'homo economicus'. This is the idea that people will make rational economic decisions. Anyone who knows of people loaded up with consumer credit will know that this is indeed a mythical creature.

According to the ITEM club, what consumers apparently are doing is sitting on piles of cash so that they can buy things cheaper in the future. It appears that the man in the street is listening to the economists, and actively withholding their spending until prices fall.

However, this is to ignore another impact of the current economic position. Every day that goes by, there are more and more headlines of job losses and falling house prices. Might it not be more likely that consumers are not spending for the following reasons:

1. Many will be scared. With mounting job losses, many people will fear for their jobs. Such fear is hardly likely to be an encouragement to spending...
   
2. Even those in work who are reasonably confident will see that there are pay freezes, working hour reductions and so forth. In such an environment, in such a climate, many will know that their annual pay rise is likely to be modest. Their expectations of their likely future wealth will be dropping. Again, hardly an encouragement to consumer spending.
3. House price falls. Many people saw the increase in the value of their homes as a safety cushion, offering a sense of security for their profligate spending. With the rapid disappearance of the safety blanket, they will not be inclined to spend so much....
4. I think the ITEM club imagines a world in which, like themselves, everybody is on a salary such that, barring redundancy, their income is fixed. However, this is to ignore the many independent tradesman and self-employed, many of whom will actually see their income dropping, even though they may not be unemployed. People with falling incomes, and insecurity about where their next work will come from are hardly likely to be spending.
   

In general, I simply do not believe in Homo Economicus. However, I do believe that he can make an appearance when there is no other option.

In all of these cases that I have provided, a more rational approach to finances is being forced upon people through fear for their own individual prospects. I would suggest that, for the majority of individuals, saving to await price falls is an economist's fantasy. Last Christmas it was proposed that consumers held off spending until the last moment in a big game of 'chicken' with the retailers. Apparently, they held back from spending because collectively they were waiting for the retailers to drop prices in their desperation to get custom. I think there may be a very small element of truth in this, but would suggest that most consumers held off because of fear (for the reasons given above), and finally caved in because an emotional sense that they wanted a 'good Christmas'.

Christmas is also a good broader illustration of the irrationality of individuals. The UK is largely a secular society, such that Christmas have very little religious significance. As such the persistence of spending so much money on presents and the other rituals of Christmas is irrational. Every consumer knows that on Boxing Day, prices will tumble. Despite this, they spend large amounts of money just before they know that prices will see massive falls. Without a religious driver, this is nothing to do with rationality - but to do with sentiment and emotion.

This whole argument about consumers deferring their spending to make savings later is actually flying in the face of the history of the last ten to twenty years (at least). The boom in credit is the exact opposite of this deferral, as people have spent before having the money and therefore have purchased at greater cost.

However, this is the justification for many of the actions of government. The deflationary theory is built upon the premise that, if consumers have an expectation of falling prices, they will defer consumption. However, as the Christmas example, and the experience of the massive growth in consumer credit suggests, this is the exact opposite of the behaviour of many consumers. Whilst there may be a number of consumers out there who are so thoughtful and rational, it is impossible to argue with the fact that huge numbers of people have been buying on credit, and therefore consume on an irrational basis.

According to the deflationary theory, this consumer behaviour has magically flipped. Why would consumers suddenly get so wise?

The real explanation for deflation is the combination of actual shrinking incomes, and fear of shrinking incomes. This means that consumers do not have as much money to spend, or fear to spend what they have. As such, every provider of consumption goods or services must work harder to gain a share of the shrinking market, including offering discounts. Those that provide goods and services to consumers are also in a battle with rational fear, and seek to overcome that fear with the prospect of ever more attractive prices.

This is the cause of deflation. Rational fear and less money available for consumption. Whilst this will create a downward spiral, it is not a spiral driven by expectations of falling prices.

It is somewhat surprising how much assumption there is in a couple of paragraphs from the ITEM club, but there is an even greater and more contentious assumption. As I have already gone into such a lengthy discourse, I will re quote the second paragraph, which concerns the second point that I would like to make:

We are now in danger of seeing the economy choke: and once you get into a situation where people are hoarding as much cash as you can throw at them and interest rates are stuck at zero, you're in real, real trouble.

At this point, I will ask you to not read on for a moment. Before reading on, see if you can spot the emotive descriptors in the paragraph. Re-read the paragraph with this in mind, and I hope you will spot a most curious expression.

In case you did not get it, the key word here is 'hoarding'. Consumers are not 'saving' money, but instead are 'hoarding' money. Hoarding is what dragons, pirates and greedy kings do with gold. Hoarding is a 'bad thing'.

However, if we rephrase the paragraph as follows, then we see a very different picture:

We are now in danger of seeing the economy choke: and once you get into a situation where people are saving as much cash as you can throw at them and interest rates are stuck at zero, you're in real, real trouble.

What we are now seeing is an argument that says that saving is a bad thing and is the destruction of the economy. If people save 'you're in real, real trouble'. The solution to this real trouble that they are proposing is quantitative easing, or printing money.

In printing money, they will relight the fires of inflation, and that inflation will apparently get consumers spending again. However, such an assumption is built upon several other assumptions.

The first of these I have already detailed - the assumption that consumers are not spending because their minds have magically flipped such that, all of a sudden, they have learnt to defer spending so that they can achieve savings.

The second assumption that they make is that spending money today is better for the economy than saving money. This ignores the fact that savings are what provides the pool of new and genuine capital for businesses to utilise in order for them to expand and grow business (note: the process of central bank money creation does not provide this, but merely shifts value from one place to another). The banks have previously lent foolishly, thereby destroying their capital base, thereby creating a situation in which they need to repair their capital base, thereby meaning that there is a shortage of credit. In order for this position to be rectified, they actually need consumer deposits. That means they need consumers to save.

Furthermore, it is very puzzling that saving might be seen as a bad thing under any circumstances. Saving is rational consumer behaviour. If a consumer saves money, they will gain interest on those savings (except where the government sets an interest rate in which no return is possible), and will therefore increase their future purchasing power. This means that they will be able to buy more with their money than they otherwise would be able to buy. In addition, this feeds into benefits in the wider economy, as has already been pointed out, by making more capital available for investment. The greater the availability of capital for investment, the cheaper the cost of capital, and the greater the profits for business.

Is this not a virtuous circle? Investment of wealth into business creates jobs, which creates income for individuals, which creates wealth for consumption and further investment...

There are two problems at present with the switch to savings. One is that savings have been very low, such that consumers have to make up for their past lack of savings. The second problem is the flipside of this - that there has been too much debt driven consumption, and that debt driven consumption can only go so far before the weight of debt becomes unsustainable. There must come a point in time at which consumers will have to start paying down debt, and at that time, overall spending will have to decrease. In such a situation there must be a contraction in consumer activity, which means that economic activity must contract, which means that unemployment must rise, incomes are likely to drop (or at least not grow), and there will therefore be greater competition for less money, which will mean more competition on prices, which means deflationary pressures.

I say these are problems, but in reality the problems are arising due to previous problems, and are actually a necessary price for them. The contraction is necessary, but it will be painful. In this sense they are problems to live with (in that they will cause hardship) but are also a correction of (and solution to) the previous problems.

As a note I have discussed before about the counter-effect of a falling currency on prices, so will not detail this point again here. My focus here is primarily on the issue of savings and deflation, and the assumptions that underlie the ITEM club thinking, and the thinking of many mainstream economists.

The key points here are that the theory of the mechanism of deflation makes a basic assumption that is not supported by the recent behaviour of consumers, and it exactly the opposite of the way that they have behaved for a very long time. The second point is that there is an assumption that saving is a bad thing for an economy, and that consumption, at whatever cost, is a good thing.

In my last post, I pointed out how there was a fetish amongst many economists for activity. Activity, by their reckoning, in any form, is a good thing - even to the point where the economic activity resultant from the destruction of Hurricane Katrina is seen as positive economic activity.

Such fetishistic obsession with activity is at the heart of the ITEM club thinking. Their primary concern is to get consumers spending again, and if that means spending borrowed money, this is not important. The fact that spending borrowed money is unsustainable is not taken into account. In the past, the borrowing was funded to a large measure by overseas lending. Their solution, in the absence of the overseas capital is to print money to lend to individuals and businesses in the hope that this will generate activity. However, such money adds absolutely no value to the economy overall, it merely moves the value of the existing money onto the printed money (which moves to the government).

Such an action is therefore simply a tax on savings and investments, meaning that the amount of capital available for investment is diminished. Not only does it destroy the value of the savings that are in place, it also is aimed at encouraging people not to save, such that the recovery of the level of capital to allow for new investment will be restricted.

What we are looking at is a situation in which the purpose of the ITEM club policy is to create an environment in which they are seeking to overcome the rational fear of consumers by destroying the value of savings - to such an extent that it is simply not worth holding money. This destruction of the value of money will encourage consumers to spend money as soon as they get it, thereby encouraging consumption.

This sounds like massive inflation, does it not?

The views of the ITEM club are not unique. Their views are a mirror of the views of governments, with the main difference in their thinking being a sense of urgency to destroy incentives to save.

There are two puzzles in all of this. The first puzzle is how anyone can believe that people saving is a bad thing. Whilst it might see further economic contraction in the short term, it is necessary to create a foundation for future recovery. Any policy which is aimed at prevention of saving is a policy that is aimed at the 'now' but at the cost of the future. The second puzzle is why on earth economists think that consumers will defer spending for cheaper prices tommorrow, when the evidence points in the other direction and where there are far more plausible explanations for why consumers are not spending. Their theory of deflation is just very odd.

When we look at the two paragraphs from the ITEM club, we can see that there is a considerable amount of assumption in their thinking. However, those assumptions, when examined, are most curious and rather muddled. When we think of government policy, we must bear in mind that their thinking will be along the same lines, even to the extent that they are using the same models.

It is more than a little bit worrying.

Note1: I have re-read my post, and I am hoping that my explanation is clear and consistent. If not, please feel free to post comments and, time allowing, I will try to clarify the points.

Note 2: Lord Keynes has responded to my reply to his comment on my last post (that is rather a mouthfull - sorry). I will try to address the points made, but do not want to go further into what the 'right' level of expenditure on education might be which, as I will explain, is a diversion (to which I previously succumbed). I do think that Lord Keynes is missing the central point, which is that if x amount of spending on education was a bad thing yesterday, why is it a good thing today? Either it was wrong yesterday, or it is wrong today. I have perhaps not explained myself well enough, so will seek to clarify my thinking.

When Keynesianism comes out of the closet, it is quite astounding how much underinvestment is suddenly recognised. Seemingly, huge tracts of previous underfunding is discovered in coincidence with the 'need' for Keynesian spending schemes. It is also noteworthy that everyone has their own pet projects that have apparently been neglected, such as public transport, green energy, education and so forth. All of these projects become 'investments', but the curiosity is that they were not deemed good investments yesterday....

In other words, the Keynesian spending becomes the route for everyone to overturn previous spending restriction on what different individuals think is important. Every one of these projects can suddenly find justifications, but these justifications were not sufficient to win the argument yesterday, at a time when there was more finance available for the project. I could get into a similar debate for any one of the wide range of spending plans and meet exactly the same level of argument and justification for each of the plans. I could devote huge amounts of time on this blog in endless arguments about the relative benefits of every one of the projects being mooted for expenditure.

The point here is that it may, or may not be, correct that one individual project is a 'good thing', but it is an absolute certainty that much of the expenditure will not go to worthwhile activity. It can not be the case that all the previous restrictions on spending were wrong.

In particular, there is a point at which government spending just becomes a wasteful drain on the economy. Otherwise, government spending could rise perpetually with no negative impact upon the economy, and only positive impacts. It is possible to argue about that level, but if we accepted the level yesterday, why should be not it accept it today?

If we do not accept this principle, if we think that government expenditure could perpetually rise and benefit the economy, we would have to accept that the government that spent the most would have the most successful economy. This is not a case of reductio ad absurdum. Caps on government spending are there so that the expenditure of government does not (in principle) lead to wasteful expenditure. Keynesian economics is the removal of those caps. If something is deemed worthy of investment, meaning that it is believed to have potential for a return greater than the capital expenditure, then it would already be funded.

Such is politics that, even without the excuse of Keynesian economics, not all government spending is necessarily justifiable, though that is a wider issue than the additional spending than the argument over Keynesianism, and is beyond the scope here. What is at issue here is why previous thought on what was an acceptable level of expenditure can suddenly, as if by magic, be overturned.

At the heart of this is that I would argue that the more a government spends, the more likely it is to waste money, though some might argue that this is not the case. If a person believes that higher government spending = greater economic success, then their starting point and mine are a long way apart, and I would have to offer a very long discourse to put my case forward. It is beyond the scope of this reply to offer such a case.

Returning to Keynesianism, at a time when there is less finance available, to increase government spending is quite simply mad. In doing so, what were previously likely to be, at the very best, marginal benefits from expenditure suddenly become compelling arguments for expenditure. This simply does not make sense.

These now 'compelling' arguments come at the cost of either massive increases in government borrowing, or printing money. This is done for projects that were yesterday deemed as being at best of marginal worth....As I said, madness, as the spending now will mean less money for spending in the future on projects which are considered to have greater potential than marginal benefits. However, many of the projects that are now being funded would normally have been dismissed as a waste of money, but are still going to be funded. In spending on projects deemed to have questionable benefits now, there will be less money in the future for projects with more assured benefits.

The choice is very simple. Waste money now on projects whose benefits are questionable or with very little benefit, or do not waste money now and have more money for better projects in the future. Which is to be?


Note 2: I have had a very interesting comment from Pete Murphy on my last post, and strongly recommend that you read it. I have often had a vague notion that the US trend of building so called MacMansions (huge houses) was a driver of consumption. However, I never thought about it in the wider context of Pete's discussion. What he says intutively makes a lot of sense, though I am still contemplating his argument on free trade. If I have time, I will try to take a look at the book he has written on the subject (as a note for Pete, I do not consider mention of your own book on economics as being spam, though if you had linked to Amazon that would be different. Your comments and mention of your work are welcome).

Banking Regulation - Buyer Beware

This post on bank and financial regulation has been under consideration for a long time. The reason why it has taken so long is that I was allowing myself to become confused, in much the same way most people become confused over these issues. The cause of this confusion is that we all seem to forget what the financial and banking system is, and what it does.

The reason I am now able to write this post is that I have had a very good comment posted on 'Financial Crisis - A Brief Review', in which the author offers an argument that deregulation caused the current financial crisis. The argument that was presented helped me to focus in on what matters, which is to ask what banks are for, and how the financial system operates. In particular, the argument that the Financial Services Modernization Act of 199, in conjunction with a fiat money system, was fingered as the guilty party (I am simplifying, so I suggest reading the original comment). The comment also pointed me to the Ludwig von Mises Institute for an article in support of the argument. The reason why the comment and this article allowed me to finally write this post was that I was preparing all kinds of complex counter arguments, including a long discussion on the Basel Accords, when I realised that I too was missing the point. Whilst I cover these issues, I am now not so concerned with these details, but more concerned with basic principles.

I was forgetting what the banking system was for, and what money is for. It is only if we remember this that we can start to think of how the system can operate effectively. If we keep these basics in mind, it will become apparent that much of the banking regulation is trying to achieve the impossible, the removal of risk. It also becomes apparent that the system of money is built on foundations of sand.

The logical starting point for reform would be the issue of what money actually is. It is not some magic substance that has a picture of a famous dead person on it, or the picture of the queen, but something which has a purpose in the exchange of goods. Lets imagine, for example, that a sofa shop owner is in need of milk for his family, and that the milk requirement is one cows worth of milk production per day. He believes that one cow's worth of milk production for the lifespan of the cow is worth one sofa in his shop.

Now, in the real world, it may be the case that I do not have a cow to provide the milk to the sofa shop owner, or a farm, or anything else which the sofa shop owner wants. However, for the sake of ease, we will say that I am in the business of providing consultancy to farmers, advising them on best practice in milking. As such, I can sell my advice for milk. My own milk requirements are very small, so I do not need all of the milk that the farmer provides in return for my advice. When I want to buy the sofa, I could therefore write a contract that, instead of providing one cow lifespan worth of milk to me in return for my services, the farmer instead directs that same milk to the sofa shop owner. As such, I am now in the position to make an exchange for the sofa, and can take it home.

As such, money is an intermediary, which allows us to not have to go through this complex process to make an exchange for a sofa. In order for money to operate in this role, so that I do not have to set up lots of contracts, the person in the shop must believe that the intermediary that I provide (money) = one cow's worth of milk over the lifespan of the cow. In other words, the shop owner would expect that the money I provide will be able to purchase milk in the quantity of one cow's production (a) over the number of days the cow will live (b). When I enter the shop without a cow or a cast iron milk supply contract, I must provide the shop owner with something which guarantees that I will provide the shop owner with a x b worth of milk, over a period of several years. In effect, that is what I am exchanging for the sofa.

In other words, money is a contract for the provision of x amounts of goods and/or services. It allows us not to have to go through life making lots of impossibly complex contracts, between all of the specialisms in which we participate, which would be quite impossible and inefficient to manage. Quite simply, it is better that we use an intermediary that offers the same contractual commitment. In order for this to work, the contract implicitly must have the same value tomorrow as it does today. When I hand over money for in exchange for the sofa, the sofa shop owner is going to get a bad deal if, in three years time, he finds that he is only able to purchase three quarters of a cow's milk production. It is for this reason that inflation is bad. It is, in effect, a breach of a contract. Whenever inflation occurs, we lose some element of our belief in money to honour the contracts between one another. I have chosen the milk production example to illustrate this point, as it is very important in the consideration of money.

To illustrate this point, I recently had a comment on a post regarding hyper-inflation and whether it is a good time to buy a house at such a time. My answer was as follows:

I have read about hyper-inflation in principle, but here is a good question of the process in practice. The first thing is that, during hyper inflation, the value of cash is destroyed. At the same time the cash price of assets rise, although their real value may not change. At its most basic, what I am trying to say is that, if a pint of milk has the same value as a loaf of bread, whilst the cash value of these may change, the relationship of the value, one to another, does not necessarily change. So it is with housing. If a house is worth 100,000 pints of milk today, all other things being equal, it will be worth 100,000 bottles of milk tomorrow. However, the value of housing was over-inflated, such that all things are not equal. As such, whilst the cash price of a house may rise, the value of that asset will presumably continue to decline relative to other assets.

Within this reply, we have a problem when we think about money. Within this scenario we have a situation where the value of one thing versus another is unstable. In the case of of the house, today it might be worth 1oo,ooo pints of milk but the next day it may only be worth 99,000. Alternatively, if there is a sudden expansion in the dairy industry, it may be that the house will be worth 110,000 the next day, as there is an oversupply of milk into the market, thereby reducing the value of milk relative to other items. This can happen to any particular product, commodity or service - and that includes gold.

If we take the value of gold, it might be that the demand for gold drops, due to a change in society where gold becomes associated with 'bling', thereby reducing the demand for gold for personal decorative use. In such a situation, there will be an oversupply of gold relative to the demand for gold, and the value in exchange of gold will drop relative to other items. The problem that I am illustrating is that nothing has a fixed and enduring value in exchange relative to other things.

Now we come to the situation of money today. As many readers will be aware, the gold standard was abandoned many years ago. The gold standard was a situation in which each unit of currency could, in principle, be exchanged for a fixed amount of gold. Today, there is no such backing, such that money has no contractual guarantee. I would therefore like to return to my milk and sofa example.

When I enter the sofa shop, bearing a fistful of bank notes, I am offering the sofa shop owner something that he believes to be a contract, but which actually is not a contract at all. If we say that there is a situation of high inflation, or hyper inflation, then there is no recourse for our sofa shop owner. I might give him £2000 which today looks like it will pay for a cow's lifetime supply of milk, but which will in three years time not be able to be used to purchase even one day's supply of milk. There is no contractual commitment in what I had handed him. None whatsoever.

How does the situation differ under the gold standard? I have already pointed out that the value in exchange of gold varies relative to other goods and services. As such, I could go into the shop and purchase the £2000 sofa in exchange for money which can be converted into x amount of gold. If there is a massive expansion in gold production, or gold was less desirable for the 'bling' factor, then it may also be the case that the gold in three years time would be insufficient to buy the milk that was required by the sofa shop owner.

In such a situation, it becomes apparent that money, in all forms, is a fundamentally flawed concept. I will commit the sin here of quoting Wikipedia, but they offer an excellent summary of what money is supposed to be:

"Money is a matter of functions four, a medium, a measure, a standard, a store."

In all cases it is very easy to achieve the first three, but the last point is the one that causes the problem. In all cases it is impossible to guarantee the last item, even with gold. If it is a store, it must be accepted that it is potentially a leaky one. In other words, whatever is used as the standard unit of exchange, it carries with it risk that the value in exchange today and tomorrow might not be the same.

We are therefore in the tricky position of having to make some choices. On the one hand, we could abandon the concept of money altogether, which would mean endless complexity in arranging reciprocal contracts between endless numbers of individuals. On the other hand we have to use something as an intermediary in exchange whose value is subject to change. The former option is simply impractical, and the latter is unsatisfactory. However, the options are just these.

From this perspective, it is apparent that there is a necessity for money, but that money needs to still retain a contractual value. Under the present system of fiat money, there is quite literally no contract whatsoever, and the value of money in exchange rests in its entirety on the delusion that there is an underlying contract. Such a system has huge risk, because if ever there comes a point where individuals demand that the contract they believe to be there is fulfilled, they will find that there is nothing there at all. It is the current situation in the Western world that there is a huge amount of money issued, that this money has been used to purchase goods and services from other countries, but there is very little that the money can actually be exchanged for. This is seen in the imbalance in trade between the East and the West (ignoring cases like Germany).

In other words, if the countries that have provided the goods and services try to exchange the money issued in the West for goods and services, they will find insufficient goods and services available for the money to purchase. We have, for example, used the money issued to buy plasma TVs from China and can not offer any good or service in return for those purchases. We have used an item in the exchange which is not actually backed up with any contractual commitment to reciprocate with anything. We are in a situation where, if the perception of the underlying contract is tested, it will be found that it does not exist. At that point, the belief in the value of money will quite literally disappear. This is the risk that has been taken.

It is at this point that we return to the very imperfect gold standard. If all currency issued is backed by gold, then there is an explicit contract. If you do not wish to use the money in exchange for any goods or services, then you have the option of exchanging the currency for a fixed amount of a commodity. Whilst there is a risk that the value of that commodity might fall in relation to its value in exchange with other commodities, goods or services, it will always have some value in exchange. It guarantees that money will always have some value. Gold is used because it has, throughout history, has a relatively high value in relation to many other commodities. However, any commodity has the same function and the question of which commodity just becomes a question of relative historical value stability, and practical questions of how it can be stored/used/transferred etc.

In short, money must have an underlying contractual commitment, or it becomes subject to losing its meaning. Whether that contract is an exchange for gold, or any other commodity, the important point is that the contract is fixed. In this way our sofa shop owner knows that, whatever happens, he will always be able to buy at least some milk with his money, even if he is unable to buy as much milk as he originally expected. It is very imperfect, but it is better than the option of being able to buy no milk at all, which is possible under a system of fiat money.

It is at this point we now need to turn to the broader issue of banking and financial regulation. Although I have not expressed any preference for which commodity might be used as a backing for money, I will stick with the gold standard as being the method of contractual commitment.

The first question that is raised is who might issue money. My answer is very simple. Anyone at all. That means you, or I, or the person next door can issue money. It is, in any case, what we do all the time. If we remember that money is an intermediary in exchange, we start to see that, for example, when we offer to do something for another person in exchange for something else, we are effectively issuing money, in some cases the unit of currency is a verbal promise, in others a contract written to say that we will do something. In both the case of the contract and the promise, they are both units of exchange.

For the purposes of the wider economy, in ensuring that exchange is efficient and effective, it is important that there are monetary units that are widely accepted. It is only in ensuring that this objective is achieved that there should be any regulation of money. Whilst anyone can issue money (though I suspect few would accept notes backed by nothing where there is a gold standard alternative), there is a regulatory role in ensuring that there is available a particular form of money that is contractually tied to gold. As such there is a regulatory role in the issuing of this money. That role is to fix the rate of exchange, ensure that it is never changed, and to ensure that money that is so fixed can be identified as such.

As such, any individual, or institution, can issue gold backed money, provided that they can demonstrate that they have the gold available to meet the standard, and that the gold is secured against sale. The role of government in such a system is to monitor the institutions that are issuing the money to ensure that they have sufficient gold, and the printing of the money in a consistent format with the issuing institution's name printed on the money. The government might also issue currency, but only if it is also backed with sufficient gold to meet the standard. The institutions that can issue money according to the gold standard would have a special designation as deposit banks. All money within these banks would be contractually guaranteed to be able to be converted into gold (or at least nearly all of it, as an allowance would be needed to allow the banks to acquire the gold as deposits rise). As these banks would not be investing money, they would need to charge a fee for the deposits.

In addition to deposit banks, there would also be an alternative, and relatively unregulated banking system, where the banks would be designated as 'speculative' banks. It is here that we come to the difficult subject of regulation. Before we continue, it is worth reviewing the two basic purposes of banks.

The first purpose of banks is as a place to store money in a relatively safe place. The deposit banks serve this purpose, and therefore there must always be deposit banks available to individuals and businesses, even if the government must step in and offer this service (the least preferable option). The second role of banks is as a conduit for investment. This is best explained by thinking of an individual who has £10,000 saved from their salary. They have several options of what to do with this money. On the one hand, they might put it into a deposit bank, which will only guarantee that, at any time in the future, that money will be able to be exchanged for a fixed amount of gold. Alternatively, they may wish to use that money for speculative investment.

The investor has several choices on how to invest that money. On the one hand, the investor has a sister who is planning to open a restaurant. She is looking within the family for investment capital. Being her brother, he knows her well, she has explained her plans, and he must therefore make a judgement on whether this is a good investment. On the other hand, he might invest the money in the company which he works for, as the company is offering shares in the company to employees in order to raise money for the development of a new product. He knows the company well, he knows the details of the plans for the new product, and can therefore reasonably judge whether it is a good investment. His final option is to outsource the investment decision to an institution specialising in investments - a speculative bank.

In all three cases there is a common factor. In all three cases he must risk some, or all, of the value of his money. In all cases, the money will be invested in projects where, if he wants the money to be returned, there is no guarantee that it will be immediately available, or whether it will ever be returned at all. All three cases are identical in this respect, and no amount of regulation will ever change this basic reality. It is here that we come to the fundamental problem of modern regulation. It is aimed at removing the risk from investment, the risk that money will not be returned to investors. It is really very simple, as soon as a person/institution wishes to gain interest on their capital, they take a risk with that capital. The only way for interest to be accrued is through investment, and all investment is speculative and inherently risky. To try to regulate risk away is therefore an impossibility, but this is the purpose behind much of the regulation.

Regulation of risk is not possible, but regulation of provision of information about risk can be regulated. If we take a look at the Basel banking accords, they do not seek to regulate information but are seeking to regulate risk. A very good discussion of the Basel accords can be found here at the Bank of England website, and I will use it as the basis of discussion. In particular, the date of the paper is 2001, and the paper therefore details the thinking of regulatory institutions pre-credit crisis. The introduction to the piece starts as follows:

The 1988 Basel Accord was a major milestone in the history of bank regulation, setting capital standards for most significant banks worldwide—it has now been adopted by more than 100 countries. After two years of deliberation, the Basel Committee on Banking Supervision has set out far-reaching proposals for revising the original Accord to align the minimum capital requirements more closely with the actual risks faced by banks.

The important point in this paragraph comes in the last sentence. This is the problem that is inherent in all regulation, that there is an objective standard of assessment of risk that can be discovered and codified. The thinking behind regulation is best summarised again in the BoE paper:

One issue when deciding on the capital requirements for
each probability-of-default band is the appropriate
solvency standard that regulators should be targeting for
minimum capital.(5) This needs to balance prudence
with efficiency. Banks are regulated to protect
depositors (because of information asymmetries and the
social consequences of loss of savings) but just as
importantly to protect the financial system. This reflects
their central role in the economy. Because of their
position in the payments system and lending to small
and medium-sized businesses and retail customers, the
cost of banking crises can be very high. Bank of
England research,(6) which examines 43 crises worldwide
over the last 25 years, indicates that economic activity
forgone during the length of a banking crisis can
amount to between 15% and 20% of annual GDP.

So here we have expressed very clearly. Bank regulation is to protect depositors. What the statement does not do is explicitly state is protect them from what. What they mean when they say protect depositors is that the intention is to protect depositors from losing their money. Such an objective is impossible, as all investment carries risk, including complete loss of all capital. The only way to protect depositors is through the provision of a deposit bank (as detailed before) and even that carries the risk that the value of gold might be subject to change. The other problem highlighted is information asymmetry between depositors and the banks. Rather than address this problem, regulation seeks to address the impossible - the elimination of risk for depositors.

The answer to this perceived problem, was Basel I. This is described in the BoE paper as follows:

The 1988 Accord represented a revolutionary approach
to setting bank capital—an agreement among the
Basel Committee member countries that their
internationally active banks would at a minimum carry
capital equivalent to 8% of risk-weighted assets (with
the Committee setting broad classes of risk weights).
The agreement was made against a background of
concerns about a decline in capital held by banks,
exacerbated by the expansion of off balance sheet
activity, and worries that banks from some jurisdictions
were seeking a short-term competitive advantage in
some markets by maintaining too low a level of
capital.
The introduction of the Accord seems to have led to
some rebuilding of capital by the banks in the G10, but
over time the broad nature of the risk categories created
strains.(2) The Accord differentiates between exposures
using general categories based on the type of loan—
exposures to sovereigns (split into OECD and
non-OECD), exposures to banks (split into OECD and
non-OECD, with the latter split into less than one year
and more than one year), retail mortgages, and other
private sector exposures. Little allowance is made for
collateral beyond cash, government securities and bank
guarantees.

So here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.

So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.

Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.

So now we come to the Basel II accord. Once again, I will quote from the BoE paper. It makes interesting reading.

The broad categories reflected the state
of systems in banks at that time. But during the
1990s, banks started to develop more sophisticated
systems to differentiate between the riskiness of various
parts of the portfolio to improve pricing and the
allocation of economic capital. These systems
highlighted the discrepancy between required capital
and economic capital for some exposures, creating an
incentive to sell some loans. The chart below sets out a
risk measure, the value at risk (VaR) over a one-year period,(1)
for portfolios of exposures in each rating
category, and shows that for loans to all borrowers down
to BBB the Basel minimum requirements of 8% capital
(of which 4% is equity) would probably be higher than
the equity capital that a bank would chose to hold.

This disincentive for banks to hold prime-quality loans
was probably one of the factors behind the securitisation
boom in the United States. By March 1998, outstanding
non-mortgage securitisations by the ten largest US bank
holding companies amounted to around $200 billion
(more than 25% of these banks’ loans).(2) Banks outside
the United States were also increasingly turning to
securitisation to adjust their portfolios. The ability of
banks to choose how much risk they wished to carry
against a particular quantum of regulatory capital
threatened to undermine the objective of an
international capital floor. Another concern about the
Accord was that the limited recognition of risk reduction
through collateral or credit derivatives would discourage
banks from taking advantage of these techniques and
more generally impair the development of markets.

I have highlighted two sections with italics, which stand as two examples which will illustrate contradictory points. In the first section, the securitisation boom is seen to be as a result of Basel I. This was to lead to many of the problems we have seen today. The second point was actually a positive point for Basel 1, which was that it was limiting the growth of credit derivatives, which are creating ongoing problems for the banking system today, but this was seen as a negative by the BoE. Basel II sought to rectify this 'failing'. In both cases, the regulation had distorting effects on the structure of markets, and in one case a positive outcome is seen as a negative. The regulators simply can not make accurate assesment of risk.

Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:

Under the standardised approach banks will slot
assets into weighting bands according to ratings from
eligible rating agencies (ie recognised by national
supervisors in accordance with specified criteria).

The BoE paper acknowledges that the rating agencies may be no better than the banks at assessing risk, but fails to acknowledge that there is a central conflict of interest - that the ratings agencies are paid for conducting the rating by the banks themselves. The importance of the poor preformance of these ratings in the current financial crisis can not be overstated. However, they were critical to the entire Basel II system:

Exposures to borrowers without a credit rating will be
placed in an unrated band that will carry a 100%
weight (ie 8% capital charge), but regulators are
requested to review the default experience of the
particular market (and individual bank) to decide
whether this is sufficient. Undrawn facilities to
corporates of less than one year, which currently
carry a zero weight, will be weighted at 20%.

At the heart of all of this regulation is an unfounded belief that, somehow, there are a bunch of people with sufficient wisdom to determine risk, and therefore create a system in which risk of failure is abolished. Such a point view can only do one thing - create complacency. It creates a situation where, provided you meet the rules, you must be sound. However, the institutions then game the rules, and seek ways to best exploit the rules. The only solution to this is ever more rules, and ever more complexity, and within that complexity the institutions will just find new ways to subvert the rules. Above all else, however, is the simple fact that it is not possible to remove risk from investments, and that risk must be an accepted part of any system, including risk of bankruptcy.

I started the post mentioning a commentator's very good and interesting argument that deregulation caused the problems. It is a good basis to discuss the idea that deregulation was the problem. One of the points made was as follows:

But, at any rate, since Basel II was not even published until June 2004, and not implemented in the US until the years after 2005 (well after the housing bubble began), how could it be a major cause of the current crisis?
Of course, Basel I (which was published in 1988 and implemented in most Western countries in 1992) could have played a role. But in the absence of the three factors discussed above (the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000, and the real estate bubble), how could Basel I have caused this on its own?

I would not suggest that Basel 1 caused the problem by itself, but rather was a contributory factor, and this can be seen in the BoE paper. The reason for the housing bubble was actually the result of a flood of capital into western markets (resultant from the shift in the world economy) with insufficient good investment opportunities to soak up the capital. Once the sound investments were gone, then there was little choice but to invest in ever more risky investments. This was compounded by the state entities of Freddie Mac and Fannie Mae having an unfair advantage in the provision of lending into prime mortgages, leaving less investment opportunities for the genuinely commercial banks. As for Basel II, it may not have caused the problems, but it certainly exacerbated the problems. In particular, putting the ratings agencies centre stage was problematic, as well as the structure for internal risk assessment.

The author of the comment, in a second comment, quotes the following:

Paulson convinced the SEC Commissioners to exempt the investment banks from maintaining reserves to cover losses on investments. The exemption granted by the SEC allowed the investment banks to leverage financial instruments beyond any bounds of prudence. In place of time-proven standards of prudence, computer models engineered by hot shots determined acceptable risk. As one result Bear Stearns, for example, pushed its leverage ratio to 33 to 1. For every one dollar in equity, the investment bank had $33 of debt!”

I would argue that this is just an example of the problem of regulation. The SEC legitimised all of this. Without such legitimacy, without the approval of a regulatory body, would this kind of practice have been so readily accepted? It is at the very heart of my argument - regulation and regulators encourage complacency. The commentator also mentioned the role of regulatory arbitrage, with the UK offering a laxer regulatory regime as a way of attracting more banking business to the UK. It is yet another example of how regulation can create distortions in the market place. The UK claimed that its 'soft touch' regulation was both sound and more efficient but, as with the US system, it was neither sound or efficient. It is possible to therefore suggest that every regulatory regime should meet the same standards of regulation, but we then encounter the Basel approach, where the risk assessment regime of both of the accords have now been shown to be wrong.

They were wrong, but conferred a false sense of security/legitimacy in the activities of the banks, much as the SEC did in the example given above.

What of the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000? These are fingered as the guilty in the cause of the financial crisis. However, I would suggest that, for example, the legal structure of financial institutions is not an issue of concern. The structure of financial instruments is not an issue of concern. As you may be gathering, the real issue of concern is the nature of the oversight of the activities of the institutions.

As the BoE suggests, there is an asymmetry of information. When I gave the example of the person investing the £10,000 I pointed to two examples in which the investor had good knowledge about the potential investments (his sister and his company). In these cases information was not a problem, but even with good information the risk remained. The problem of information arose with the speculative bank. How can an investor make an assessment of an institution as complex as a bank in the assessment of risk. How can he know what an SIV or CDO actually are. It is here that we have the assymetry of information.

Before continuing, a quick question. Should the investment of our investor's money in his sister's restaurant be subject to regulation? Just as putting money in a speculative bank risks the life savings of our investor, so does investment in his sister's new business. Regulation is there to protect the investments of depositors, but why would that protection not apply to investment in his sister's new business. In both cases, if the investment of that money goes wrong, then he loses his savings. For some reason, when the word 'bank' is mentioned, confusion arises. We MUST protect the savings of individuals invested in banks, but not if an individual invests in other ways. Why? In both cases the individual might lose all their money, so investing in his sister's business should be regulated, if regulation is to be meaningful and consistent.

For example, if the government guarantees money invested through a bank, why would it not do the same if the business of the sister of our investor goes bankrupt. In both cases the money was used for investment, in both cases our investor lost his savings. Where is the difference? As I said, mention of the word 'bank' seems to change everything, but I can see no rational explanation of why this should be the case. An investment is an investment, whatever the conduit.

The classic picture conjured up in defence of the regulation is that of a little old lady losing her life savings. My answer to this is the deposit banks. If, however, the little old lady wishes to venture outside the relative safety of a deposit bank, then she must accept that she moves into risk, including risk to all of her capital. However, the problem is just the same for all investors, and conjuring up images of little old ladies is just an emotive argument. A 30 year old man with a family to support will also be hurt badly if he loses all of his savings.

So how can this problem be overcome, the problem that when we invest money, we are subject to great risks? The answer is that the problem can never be overcome, but can be mitigated with information. In particular, the nature and source of the information needs to be regulated.

As such, the most important piece of regulation would be to actually make it illegal for banks, or any other financial institution, to pay for any kind of rating on their overall financial status, or the status of any of their products. It is obvious really, but the users of the ratings need to pay for the ratings if their interests are to be represented. As long as the banks pay for their own ratings, their is a fundamental conflict of interest.

The other regulation is even more straightforward. All of the speculative banks need to call themselves by this title, as a constant reminder of their nature. Whenever an account is opened, a standard form will state that they make no guarantee of the return of any cash deposited in their care, and that the person opening the account must declare that they accept the conditions. In addition, on a daily basis, they would be regulated to publish their daily (gold standard) cash reserves available for immediate withdrawl as % of deposits, as well as a monthly rolling statement of % change upwards and downwards. These would be audited on a random basis, with massive fines for any attempt to massage/distort the figures. The figures would be published on their websites and, where a bank has branches, published in the all of the branches in a predetermined format.

The aim of such a measure is to remove the complacent belief that any investment is safe. It is to remind individuals and business that they should take care over where they place their money. It is a climate of fear, and one which will encourage people to pay for services which critically scrutinise the state of the banks. A climate of fear sounds unpleasant, but it is the only discipline that will ensure that investors and depositors have a care for the use of their money. In addition, there is the security of the deposit banks, which will always be an option if the fear of the unregulated sector is too great for any individual. The deposit banks offer greater security than the existing banking system. In addition, other banks will take intermediate risk positions, maintaining relatively high cash reserves, but at the cost of smaller returns on money invested. This is the nature of all investment - the trade off between risks and returns. In a deposit bank, almost no risk and no returns.

At the heart of this argument, I keep on returning to risk, and the impossibility of the removal of risk. Even a deposit bank, backed by gold has risk. Any regulation that suggests that it removes risk is a delusion, and this has been demonstrated in this financial crisis. What was safe is now unsafe, and the regulators have been found to be wrong.

As such, my proposed reform does nothing to remove risk, or to attempt to mitigate risk. The aim of the system is simply to make the nature of the risk more transparent. Despite this, little old ladies, and 30 year old family men, will lose their savings. However, if that little old lady were to lose her money through investing in her grand daughter's business, no one would call for regulation of the granddaughter's business or ask that she not be allowed to ask her grandmother for investment.

As I said at the start, banks just serve two purposes. A relatively safe place to leave your money, or as a conduit for the risky business of investment. I have proposed a return to the gold standard, not because I believe that it is risk free, but because it provides for an alternative that offers people a certain contractual guarantee, albeit a guarantee with a limitation that the value of that guarantee is variable. It allows for deposit banks to offer a fairly low risk, but nevertheless a risk. It also supports the value of money, through offering an explicit contract. The value of that contract may vary, but the contract remains regardless of any change of circumstance.

I am not sure that I have done this subject full justice, but hope that, at least, it presents a challenge to the belief that banks must be regulated. There is a lot more detail that I would like to discuss, but time is (as ever) too short and I have other comitments that I need to attend to. I am also sure that there will be faults in my thinking, so I look forward to the astute readers of this blog pointing out the problems.

Note 1: I have not responded to the many posts over the last few days, as this has been a bit of a long and demanding post. As ever, I will try to catch up, though the backlog seems to get bigger by the day.

Note 2: I have reread the post, and apologies that it is a bit clunky in places. I hope that it is clear enough.

Bernanke and Paulson - the Dynamic Duo?

The world is waiting nervously to see whether the bailout of the financial system will actually go ahead, with ever more dissent coming from congress in the United States. If the article I have cited is correct, it is not economics in the driving seat, but politics. Bearing in mind that the economists have got it so wrong in the past, perhaps (for once) that is a good thing.

Meanwhile, one of the curiosities of recent days is that oil has risen in price. This really is quite baffling, though not in the sense that it is rising through hidden unknown mechanisms. The baffling part is that oil is not something that can be stored, and has to be sold according to a price that is set by demand. Unless those investing in oil know that there will be a cut in supply, it is not entirely clear how they seek to profit, or even find safety in this commodity. Oil prices were falling previously for a good reason; that demand across the OECD was falling back. As such, they now have the oil, but they need to actually sell it to end users at a price that will cover their buying price. As ever, those who got in early stand to profit from this, but the followers will surely lose money - unless I am missing something critical here? On the other hand the flight to gold makes more sense, as gold is currently being driven by sentiment (a flight to safety), and can be held over the long term. At this point, you may ask for the difference. In crude terms, gold can be locked away and be held over long periods of time, whereas oil can not be stored in significant quantities. As I have said, perhaps I am missing something here, but I do not think so.

This situation perhaps illustrates the underlying fear in the market. On a related issue it appears that there are tremors over the state of the emerging markets:

'"The big surprise in store is what could happen in China. The potential for a deep recession in the US is already on the radar screen, but people will be stunned if China's economy contracts, as I believe it will. Investors could be massively caught out," he said.

"The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year."'

And

'The gloomy forecast comes as Fitch Ratings warns of mounting distress for banks in China, where debt has been shunted off books to circumvent state limits on credit growth.

The pattern looks eerily like the use of "conduits" by Western banks at the height of the credit bubble'

I have mentioned before that China is opaque, and whether it would be pulled down by the crisis was not entirely clear. I recommend you read my original post on China, as it covers both the positives and negatives in the Chinese economy, and explains why it is that it is so difficult to see the economy clearly.In my original post on China, I had the following to say in conclusion to my discussion of Chinese banks (having pointed out that their commercial and domestic property were looking like a bubble):

'In light of this, I must conclude that there may still be some suspect lending from the Chinese banks. This is pure speculation, but is based on experience 'on the ground'. This raises the possibility that there is also bad lending into business, in particular to the state owned firms. Such lending is not so visible, so it is impossible to say if this is the case.'

However, before writing off the Chinese economy, I would suggest taking a look at the post, as there are significant strengths. The fact that the problems of the US and Europe would hurt China was always evident (and something I predicted). However, whether the damage from the West is enough to pull back the Chinese economy into recession was my question. If it is correct and, as I suspected, the Chinese banks have continued their poor lending, then the balance tilts towards serious problems for China. This is a very worrying thought, as the legitimacy of the Chinese Communist Party is built largely on economic growth and nationalism. If economic growth fails.....

The same article is suggesting that there may be a worldwide recession, and readers of my posts will find this to be no surprise. The real question is how the pain will be spread, and it has always been my belief that the West is going to be where the real hurt happens. However, if we throw unrest (Revolution? War?) into the Chinese equation, then all bets are off. At that point we will enter a state of chaos from which anything may emerge. It was one of the points made in my original post. However, this is just one report, and as I have emphasised, China is opaque; call it a wild card if you will.

What of investing in Asia? I have already suggested that their markets will fall along with Western markets, but that there currencies will see strengthening, which should offset the pain of the falls for those who move their money into the emerging economies early. However, if China does fall, then political risk across Asia will be sky high. It is for these reasons that I have been emphasising that there is no real safe haven at the moment, except possibly gold. In the short term I suspect that we will see some strange market movements. The flight to safety into oil suggests that there is a considerable degree of panic, and panic does not aid rational thought.

In the meantime, the world waits on the success or failure of the 'dynamic duo' of Paulson and Bernanke. However, their intervention does not promise to save the day, because no super heroes are large or powerful enough to overturn economic reality. The curious point for them is that, whatever they do, history will be kind to them. If they fail, and the anyway inevitable crisis ensues, everyone will suggest that 'if only they had been listened to', and if they succeed the economy will still crash, and it will be seen as a valiant effort, but just not enough. In short, the idea that something could be done will persist.

An analogy for this is to think of a company that has long been successful. The management of the company changes, and they cut back on investment, increase the pay of their workers, and enjoy the comfort of market leadership. As time goes on, they fail to note that new companies are entering their markets, taking market share, and fail to react. Instead, they raise ever more money on the markets, and the market keeps paying. However, they are loading up with debt, and they are starting to use debt to pay back debt. Can anything be done to stave off disaster in the short term? They are broke - their revenues are falling, they have lost market share, and their lack of investment has left them poorly equipped to fight back. No one wants to lend anymore...

So, can our dynamic duo save the day? I will let you draw your own conclusions.

Note 1: I was posting on a forum and dug out one of the useful resources that I occasionally dig into for information. The resource can be found here. It is the Bank of England document on recent developments:

'Chart 1 shows the extent to which the United Kingdom’s gross external assets and liabilities have grown since 1990. In this 13-year period, both assets and liabilities
have increased by more than £2.6 trillion, at an average annual rate of more than 11%. This easily outstripped the 5.4% average annual growth rate of nominal UK
GDP over the same period. At end-2003, external assets stood at £3.55 trillion and external liabilities stood at £3.60 trillion.'

When we factor in that they include the multiplier effects from increase in debt are factored into economic growth, such that the GDP figures are completely removed from the the reality of real growth, then we have a very worrying situation indeed (these are problems discussed through various places in the blog).

Note 2: Just a quick comment on Gordon Brown cleaning up the City and the world financial system:

'Mr Brown will call today for global regulation. "Because the flows of capital are global, then supervision can no longer just be national but has to be global. And if we make these changes I believe London will retain its rightful place as the financial centre of the world.'

The first problem is that (as I have argued previously) it is actually regulation causing all the problems. The second problem is one of practicality. How can different systems across the world all find a common standard. The third problem is that, if all the world uses the same system, then the entire world system will all go down at once if there is a major failure in that system (an analogy that comes to mind was a historical calamity in which the whole of the US used the same variety of wheat, such that when a disease struck the whole years crop was devastated). As it is the system is interconnected, but at least different systems will have different vulnerabilites and exposures.

Happily, as trying to set up such a financial system will be akin to herding cats, it is very unlikely (I hope) to succeed. As such it is probably just grand standing, to be seen to be doing something; and an attempt to portray gravitas. As for the idea of regulation of banking pay, I have yet to see any solid proposal that goes beyond rhetoric, but the idea of government control of remuneration is one which brings the word 'despair' to mind. The banks may have been foolish, but much of the root cause for the foolishness was that all the banks were 'sound'.....and the reason that they were sound was because they met regulatory requirements. The fact that their capital base was built upon toxic waste slipped the regulators by....and now there is talk about regulation of remuneration?

Note for Tin Hat: In reply to your question, I have no secret investment tips. I just arranged my life such that (hopefully) the crisis will mostly pass me by.

Last Note: Just a point on the valuation of emerging market investments. A simple way to look at it is imagine you invest $1 in a US stock, and $1 in an asian stock, and both stocks fall equally in percentage terms in their markets. If the Asia currency is appreciateing against the dollar, even though the Asian stock has dropped in value, at least part of your wealth has been retained through the fact that when you sell that stock, the currency will ameliorate the effects of the fall in the stock value, as the value is measured against local exchange rates. Sorry, to mention this if it is obvious to you all, but just in case....

More on the UK

I have had several comments posted over the last couple of days, so I will try to address these briefly. The first post is provided by Anonymous, who asks:

'I would be interested to hear who you think the (few) winners will be in the UK business world. What do Asians want to buy from the West? Should business to consumer (B2C) companies look at getting their websites fully translated into Chinese/Hindu?etc.? Could they tap into that emerging market, selling collectibles or other specialist items?'

Dealing with the first question, it is actually very difficult.

The way to think about this is to ask the question of what consumers are likely to do next. In tough times, what will people spend their money on, and what will they give up? The first thing to go are luxuries such as taxis. Secondly, people will not have the money or inclination to spend as much money on home improvements, new furniture, or the latest gadget. Upgrading the car will happen less. Foreign holidays will be more expensive (a falling £GB) and are a luxury, so there may be a switch to domestic holidays, but overall less holidays away from home. For leisure, the evening in with a bottle of wine, a movie, and take-away food will replace the restaurant, cinema, theatre and bars. Designer labels will be less alluring, as people trade down the cost ladder. Where before a person might buy Gucci, they will buy Gap, where they typically buy Gap, they will buy M&S and so forth. Hobbies will come back centre stage in people's lives, replacing shopping as the number one leisure pursuit.

We can think about the kinds of companies that will benefit from such a change in consumer behaviour - those who provide for cheap entertainment. That means video games retailers, home delivery food companies and so on. The discount retailers will benefit. Think Lidl and Poundstretcher. Discount pubs and fast food restaurants will be fine, but up market restaurants will suffer a bloodbath. Retailers able to contain/lower their costs will survive, those that do not - will not.

In the wider economy, manufacturers who have a unique technology or process will improve profits as their costs fall, provided that they have export markets (where the drop in the £GB will help them). For any manufacturers who are primarily serving the UK market, they will struggle mightily. Exporters in general will benefit, and may see real growth, but the growth will be slow to start, whilst the world economy goes through turbulence.

On a more depressing note, debt collection will be a growth business, as will be the companies involved in liquidations, from the insolvency accountants through to the auction houses. Second hand stores and second hand car dealers will possibly do well, and eBay and Craigs list will do well.

What do Asians want from the West? Production machinery, high tech products, machine tools, process design, and designer goods. Pharmaceuticals, medical equipment, insurance, weapons. It is a difficult list to compile, as there are many goods and services that the West still excels at. The trouble is that, Asia is already fast climbing up the technological tree, and is already starting to compete in many of these areas. The only answer is a rebalancing of the cost base of the West to allow the continuation of the strengths in these areas, as well as starting to protect the intellectual property that is the foundation of such advantages.

As for selling through the Internet, there are some problems to overcome in this respect. If you look at China, for example, there is a problem with trust. There are some Chinese companies that are managing this, for example through Cash on Delivery systems. However, there are many challenges to overcome that require an in depth understanding of the Chinese market. You should also be aware that China already has an excellent Internet infrastructure, and already have excellent content and services. As for selling collectibles, I have no idea, but this could only be a small business.

On reading the above post, I am aware of the gloomy picture that I have painted in my other posts. However, the West does still have some outstanding businesses, and outstanding technologies. All is not lost, or at least not yet lost. There are solutions to the challenge of the East, but they require fundamental changes to the structure of our economies. As our currencies shrink (which means we get poorer), we will gain back some competitive advantage, and this will lead to an element of the rebalancing - things will get better eventually. The challenge will be to deal with our other cost disadvantages, such as over-regulation and taxation. On the plus side, we have strong legal systems and relatively little corruption, and a moderately well educated and healthy work force, as well as (variably) good infrastructure. The trouble is that, even if we get these elements right, we are shackled with bad debt, and a collapsing banking system, and that will (in any event) take time to work through the system. All of this will take time, and political will.

Dan, another poster, suggests the following:

'For the individual, asset liquidation should be embarked upon as quickly as you can. If you have got things lying around your home that you no longer need then sell them now. Toys, gadgets, antiques and all our detritus is going to be worth much less in the coming months. Sell them now, while there are still people with money to spend.'

Certainly, if you have assets you do not need, or of no value to you now, then there is no harm in selling them now if you would in any case sell them later. With regards to real estate, getting out now is better than later, if you own more than your home. However, you will be selling into a falling market so better to discount early to get the sale, rather than hang on until later, when the discount might be larger.

Anonymous2 also suggests investing into Asia. For this, I would advise caution, as Asia is fraught with political risk, as can be seen in my post on China. I have hesitated to suggest where to put money for the very reason that the world economy is now so turbulent. The interconnectedness of the world economy and trading system means that the problems of the West will have knock on effects in the East. Add to this the instability (e.g. Thailand and Cambodia are currently close to armed confrontation) - and the conclusion is that there is no safe haven.

Lemming (now a regular commentator on my posts) asks the following:

'So, would it be loosely correct to summarise that we have two trading blocks: China and the rest of the world? On paper, the rest of the world is heavily-indebted to China, but can show that China has benefitted from stolen intellectual property.

Does the rest of the world have to honour its debts to China?

Things seem so bad that the only way out of it might be some sort of drastic 'resetting' of the world economy. Or must we work through the consequences of all the millions of individual failed deals and transactions in order to preserve the purity of 'capitalism' for an eventual return to better days?'

The short answer to this question is 'yes', we must honour our debts to China. To not do so would see a complete closure of the world trading system. Without such a system, we would all suffer. The explanation for why open and fair trade works is beyond the scope of a short answer. The trouble is that the trade has not been open and fair, and this is part of the reason for the current problems. Trying to rectify previous failings by now refusing to honour debt obligations would not be a solution. The solution for the US and Europe is to give China a clear warning - fix the intellectual property problems by 'x' degree, by 'x' date, or face trade sanctions. Furthermore, give China a fixed period of time to enact a fully floating currency.

The trouble with such a scenario is that, as happened previously, China will just threaten to sell the $US that they hold onto the open market, thereby destroying the US economy (and probably other currencies too). The way that they did this previously was to use a Chinese 'think tank' to suggest that this was a possibility (I recall that it was during a period when the US was threatening action over faulty merchandise, but can not be sure I have remembered correctly), then the government denied that this was policy. This is quite a typical method in Chinese politics, as those who have studied China closely will be aware. Use a proxy to set up the scenario, rather than make a direct confrontation.

My own answer to this is that it is better to take the pain now, and face down China now, rather than later. It is to reshape the trading system such that it becomes fair. The price of such reshaping may well result in things getting much worse before they get better. It is a short term severe pain to offset longer term worse pain. My answer lies in reshaping of the structure of the Western economies to put them into shape to meet the challenges of Asia. I hope to post more on how to do that in the future.

As a note, I had the following comment on my post on the 'Economic Rise of China':

'..but shouldn't Europe be grateful that the Chinese Government are not suing us for the defects in the last intellectual property they acquired: Marxism?'

All I can say is, a very witty comment.......