UK: The Coming Crisis

I have been given a fascinating link from a regular commentator, 'Death to Bubble Addicts' (many thanks!), which is Dr. Tim Morgan's (of Tullett Prebon - TB) report called 'Thinking the Unthinkable: Might there be no way out for Britain'. The link was in a comment on my last post titled 'Austerity of Luxury', in which I argued that there is a disconnect between resources available to government and the extent of government. The post was discussing the disconnect in general, but the Tullett Prebon (TB) report looks at the same issues that I discussed in painful detail for the UK economy. Interestingly, the report mirrors much of the argument of this blog, including a discussion of some of the foundations of the UK's problems, that I discussed in an essay called 'A Funny View of Wealth' in 2007, and which I first published in the blog in 2008.

When writing 'A Funny View of Wealth', I looked for an explanation of the miracle of growth in the UK economy during the 'boom years', looking at figures for manufacturing, commodities, tourism and other sectors such as financial services. In each case, I found that there was nothing which might have explained why the UK economy had been growing so fast, and how it was that the UK was apparently so wealthy. What I did find, however, was growth in debt, and identified that the source of the debt was borrowing from overseas. The only explanation I could see for the apparent 'wealth' of the UK economy was that we were borrowing ourselves into economic oblivion, borrowing for consumption, not for investment. I recommend that you read the essay (it is a bit long), as it is still as relevant today as when I first wrote it.

I recount this argument, as the TB report has done a great job of putting together some figures and charts to make the same point:
 

All Figures from Page 49

They do not include some of the sectors that I originally looked at, but the picture is nevertheless pretty clear. What we can see is a graphic illustration of what a debt bubble looks like. Perhaps the most important point in the TB report is that they have understood that the massive accumulation of debt during the so-called boom has had a profound effect on the structure of the UK's economy. Mirroring one of my long standing arguments, the report recognises that the UK is not just faced with paying down the mountain of debt, but must do so as large parts of the economy that were sustained by debt-fuelled consumption shrink back.

TB recognise the downwards spiral, where reduction in debt accumulation sees the shrinkage of sectors of the economy, with the knock on effects for unemployment, for tax revenue and for GDP figures. They quite rightly recognise that, even as the government cuts, the shrinkage in the economy will lead to the concern of lenders, as it becomes apparent that the UK economy is much less productive than they thought.The lenders, taking fright at the parlous state of the economy either refuse to lend of do so at a cost that will further accelerate the downwards spiral, with higher interest payments levering the economy downwards.

TB are confronting the problem that, with the debt fuelled sectors of the economy in retreat, it is difficult to see where the replacement growth in the economy might come from. There is a fundamental belief that economic growth will simply turn up from somewhere. However, as they correctly point out, it is apparent that there is no obvious sector which will provide the growth. With much of the economy structured around debt consumption, and shrinking back, where exactly will the growth come from??? With major trading partners such as the EU in crisis and also going through severe problems, it seems that there is no prospect of export led growth. Furthermore, the evidence from the devaluation of sterling over the last few years is indicative that export led growth is improbable.

What I like most about the report is that they recognise the sense of entitlement; the belief that the UK should be wealthy regardless of the actual circumstances of what the UK economy does. They recognise that there is a culture of entitlement that pervades both individuals and government, and that this explains the 'something will turn up' attitude to the current crisis. With wealth as an entitlement, then something will turn up, and economic growth will happen as if by magic. How could it not happen?

And here is the crunch. The TB report accepts that the UK has been 'kicking the can down the road', but also that this approach has about run its course. It is a situation in which the UK is about to be confronted, finally, with the storm that was brewed during the bubble years. They accept that there is no policy that can turn back the storm; the only question is to what will finally provoke the denouement. Recognising that there is no turning away from the storm, they argue that the answer for the UK is to make structural reforms to the economy to pave the way for future growth. Again, all this mirrors the arguments of this blog. However, again in line with this blog, they see the entrenched interests that will work against this kind of reform, as different sectors of society seek to retain their particular privileges and benefits. Their answer is to confront the UK population with the severity of the situation, and try to combine this with an agenda for liberty.

On this last point, whilst I am sympathetic with their aims, I have some measure of doubt as to whether this will work. However, bearing in mind that the crisis facing the UK cannot be turned back, any straw to clutch must be of some benefit. My only other worry with the report is that, although agreeing with many of the points, the report sometimes reads as highly partisan. I agree that the past Labour government were foolish, and can understand the anger that implicitly lurks in the report. However, as I try to do in this blog (not always successfully), it is better to be more studiously neutral; let the situation speak for itself.

Notwithstanding the quibbles at the end, I would strongly recommend that readers take a look at the TB report. At first glance it looks very long, but a large amount of the report is devoted to graphics, so it is relatively quick read. TB are a significant player in the financial system, and it is fascinating to see that many of the arguments of this blog, in particular with reference to the UK, are being considered in such a high profile organisation. The unfortunate part is that they confirm my own understanding of the situation, and sometimes you hope that time will prove you wrong.

Note Added Shortly After the Main Post:

I nearly forgot to mention - one of the comments on the post on Austerity versus Luxury made the following comment:

"There is absolutely no justification for government borrowing in principle. As I have argued, government borrowing is fundamentally problematic. "
What, none? That might make sense over the course of an economic cycle, but surely it's valuable to have in-built stabilisers within the cycle - cyclical surpluses to stop the economy growing too fast and cyclical deficits to mitigate recessions. It's not borrowing per se that has wrecked the West, but structural borrowing throughout successive cycles.

The anonymous commentator quotes one of my key quotes from the post at the start. It is good to see that the commentator agrees in principle with the argument put forward in the post. However,  the comment makes the assumption that government is incapable of actually saving money during the economic cycle in preparation for a downturn. This kind of thinking is an example of the kind of inertia that I mentioned in the post. Governments do not save money, they borrow money. Why? Why can a government not save money for a rainy day, just as individuals do?

I must emphasise that this is in no way a critique of the comment. This was a very useful comment, as it prompted me to ask the question about the assumption. As such, I am very grateful for the comment. In light of the current situation, the focus of the post was, focused upon no borrowing. Going forwards, in the astounding event that government borrowing is one day completely paid down, this is the simple solution to cyclicality. If we can reasonably expect downturns, it seems reasonable to save to ameliorate the negative consequences of the expected downturns.

The Use of the Expression 'Sterling Crisis' Increases Day by Day

It seems to be that jury is still out on the prospects for the UK economy; there are still a few analysts that believe that the UK might suddenly motor ahead. However, increasingly the commentators, analysts, and even some politicians, are coming to the view that the UK is in deep, deep trouble. For regular readers of this blog, this will come as no surprise, as they will know that the brewing crisis in the UK was apparent many years ago, and that the government's action has only served to increase the scope of any coming crisis.

One particular commentary in the Telegraph sums up many of the concerns for the UK economy, as follows:

Is it remotely possible that Mr Brown has succeeded not just in delaying the pain, but suspending it entirely? Here's why not. The key questions are these. Given the amount of policy action that has already been thrown at the problem, how come there is still so little sign of recovery? And by extension, will continuing to provide life support eventually produce the sustained recovery the Prime Minister promises, or will it only bankrupt the country before we get there?

When I first started this blog, I suggested that the UK was already bankrupt, and that it was just a question of time before this was accepted. I proposed that it would be necessary for either the UK to print money or default on debt and, lo and behold, the money printing solution appeared from nowhere with the Bank of England inventing justifications for the policy. When quantitative easing (QE- the euphemism for printing money) was finally introduced, I argued that it was nothing more than a method to pay for government profligacy, but nevertheless the vast majority of commentators and analysts bought into the Bank of England's justifications. It seems that they are increasingly rumbling the game:

Ian Stannard, currency strategist at BNP Paribas, said markets are fretting over how the UK will cover its deficit following the pause in quantitative easing by the Bank of England. The Bank has absorbed £200bn of debt, more than total Treasury issuance over the last year.

"The UK may have difficulty in attracting extra investors to fill the gap. We think they will have to do more QE as recovery falters," he said.

It has taken a long while, but it is starting to look like the game is up for QE. The Bank of England has described the current ending of QE as a 'pause', but that they may restart if they deem that the economic situation warrants it. The problem that the Bank of England faces is this; they originally justified QE through spreading fear of Consumer Price Index (CPI) deflation, even though no such deflation had yet occurred. They also, as I pointed out at the time, sought to mix in the use of the RPI measures, even though this was beyond their remit. As things stand, the UK inflation rate is high at the moment, and climbing:

It might be noted that RPI went into deflation, but RPI includes housing costs, which are determined by the Bank of England interest rates. At the time QE started, I predicted inflation being imported through currency devaluation. The same situation applies now, with the £GB continuing to sink:

LONDON, March 10 (Reuters) - The Bank of England's trade-weighted sterling index fell to a fresh 11-month low on Wednesday in the wake of data showing an unexpected fall in British manufacturing output in January.

The much hoped for improvement of the balance of trade has also not taken place. In fact, the opposite has taken place. The increase in imports, alongside a devaluing currency, does not bode well for inflation.

The current account situation is also seeing no improvement. As I have suggested before, the importation of inflation through currency devaluation takes time to fully impact, as many contracts and goods in transit take time to adjust to the new situation. As such, we can expect ongoing inflationary pressures lagging the devaluations.

In this circumstance, with inflation climbing, and realistic prospects of even more inflation, how might the Bank of England explain any further QE? When the Bank of England last started QE, they justified the policy with projections of CPI deflation, but the deflation never took place. It might be argued that this was because of QE, but even before the policy might have had an effect, there was no deflation (also, the idea that deflation is an inherently bad thing is something I have contested in previous posts). I doubt the Bank of England will get away with QE so easily this time around, as too many analysts are becoming cynical.

What we are now seeing in the UK is the brewing of a perfect storm. The underlying size of the UK economy, the size of the economy without borrowing, is very much smaller than many imagine. It simply can not support the level of borrowing that has been undertaken by the government. This was true even before the borrowing binge following the onset of the economic crisis, but the difference is now that the borrowing is concentrated in the government rather than consumers. The real size of the economy in relation to borrowing is the underlying problem, but other factors are adding to this fundamental problem.

One of these, which is commonly reported as a reason for weakness in the £GB and gilts (UK government bonds), is the political instability, and the prospect of an ineffective government after the coming election. This from the Wall Street Journal:

NEW YORK (Dow Jones)--The U.K. pound tumbled against the dollar and the euro Monday as investors worried that the upcoming national election could result in political gridlock, hampering the country's ability to deal with its growing debt levels.

Such sentiments are not rare, but there are other concerns, and in particular the relative health of the UK economy in relation to other economies. As governments issue record levels of debt, the competition for who is funded is intensifying. Again, it is an argument that I made long ago, and it is now an argument that is gaining a broader airing. Whilst other economies may look very bad, the credit will flow to the countries that look least bad and the UK is not well placed in such a competition. The result is that yields on gilts are climbing, meaning that funding the government is already becoming more expensive:

Yields on 10-year gilts have already crept up to 4.14pc, compared to 3.94pc for Italian bonds, 3.48pc for French bonds, and 3.19pc for German Bunds, though part of this reflects worries about higher inflation in Britain.

I undertook a search for 'sterling crisis', and the results speak for themselves. Some examples of the articles including the term can be found here and here. It is the increasing frequency of the discussion that is of real concern. As the £GB falls, as the doubts about fiscal policy gather more weight, as the prospects of a return to QE are discussed, the attractiveness of funding UK government debt diminishes. As concerns grow, the £GB weakens further, and as the £GB weakens the doubts are reinforced. However, underneath it all, the core problem is doubt about the solvency of the UK.

Just as in Greece, it appears that the electorate in the UK are taking their creditors for granted, and have not accepted (yet) that it is possible for the credit taps to switched off. The Labour Party and the Conservative Party are running scared of the polls, and are afraid to propose the cuts necessary to restore the UK's fiscal situation. The Conservatives talk of concern for the credit rating of the UK, but are not offering the policy proposals that might reassure creditors. Meanwhile, the Labour government is suggesting that the coming pre-election budget will be 'business as usual', even whilst a currency and funding crisis is brewing. At some point, the UK electorate needs to wake up and accept reality, but the prospects for this are dim.

In a recent article in the Economist (last week's print edition), they discussed the coming battle between the interests of the older generation and the younger, and the private and public sector. Of note is that, with an increasingly large share of the UK economy in the hands of government, the government us building a client state - where any serious cuts to government expenditure threatens the livelihoods of ever more individuals. The more the government spends, the more people are dependent on government expenditure, and the harder it becomes to develop the political will to cut expenditure. My guess (and it is no more than a guess) is that underlying the uncertain outcome of the coming election is the imbalance between a growing client state, and those in the private sector.

The Economist, which seems to be returning to better analysis, suggests that, in the end, it will finally be necessary for countries like the UK to have reform imposed upon them from outside. In other words, the politicians will need a crisis for them to tackle the structural problems within their economy. It is rather a depressing indictment of the politicians that are supposed to lead us, that they need such a crisis to do what should in any case be done. Within all of this is the concern that the UK is supposed to be a 'mature' democracy, in which the electorate should know better. It seems though, that they lack the maturity to face up to the severity of the economic situation.

The truth is this; if the UK continues on the current course, there will be wider and deeper damage when resolution is imposed from outside, and the wider and deeper the damage the more people who will lose their livelihoods, including the current clients of the government. In other words, nobody will win from carrying on with the current situation. Those who live as clients of the government need to recognise that their interests are inextricably bound up with the private sector. It is in not in the interest of anybody to risk a funding and sterling crisis. In the end, everybody will bear a share of the pain. Somehow, I doubt that this will be learnt before the coming election, but we can but hope....perhaps then the politicians will have the courage to do what must be done?

Note 1: Thanks for the many comments on the last post.

Lemming asks how we might determine sustainable economic growth. I am not sure that there is an easy answer to this in the current system. In particular, the manipulations of the money supply by central banks, in conjunction with fiscal tinkering, serve to bury what the real state of economies might be. A particular problem is that the policy of government 'x' can have unexpected impacts on country 'y', such as the way that QE and zero interest rates encouraged asset price inflation in countries like the US. How is it possible to untangle such effects? I long ago provided (what I believe to be) a solution to these problems, but doubt the solution would ever be adopted.

A commentator called 'D' noted that there is a situation in which government is in bed with select businesses, and suggests that this means not all blame should be placed with the government. I would argue that this is still a problem of government, as government should not put itself in this position. The more honey in the government pot, the greater the number of bees buzzing around the pot. The solution is less honey in the pot, and some fierce constitutional constraints. Sorry, a short answer, but all I have time for.

An anonymous poster corrected me that, in the event of default, somebody still pays; in this case the creditor. You are quite right, but I hope that this was implicit in the rest of the post.

'Rural Idiocy' added an interesting quote as follows:

"The Bank for International Settlements says Britain needs a primary surplus of 5.8pc of GDP for a decade to stabilise debt at pre-crisis levels, given the ageing crunch as well. The figure is 6.4pc for Japan, 4.3pc for the US and France."

Certainly food for thought.

As ever, Lord Keynes also posted several comments which challenge the views of this blog. It is always good to see the alternative views presented. As for the other comments, I have read them with interest, but do not have time to respond to them all. However, they reflect the high standards of commentary on this blog, and I feel privileged to have such a thoughtful readership.

Note 2: As with many posts, there is much else that I could say, and many subjects that might demand more attention. For example, I could talk more about the other indicators for the UK economy, but will leave that for this time. If time allows, I may try a full review of the UK in the future.

The Close of 2009

As 2009 comes to an end, where does the UK economy stand? As is common practice at this time of year, I thought a review (and commentary) might be appropriate.

There is some good news. It seems that UK households have finally realised that they actually need to save money, and that they are preparing for tougher times ahead. Of course, some of the Keynesian discussion about how bad it is to save in a recession being trotted out, but even the Times is dismissing this concern:

[referring to the Keynes argument] But that does not not appear to be the case here. Instead, all the evidence points to the savings ratio improving simply because of a number of the most heavily indebted households paying down their borrowings, along with a of minority of households overpaying their mortgages. That in itself does not necessarily jeopardise growth prospects — such as they are — for 2010 and is probably worth celebrating in that it confirms a long-overdue recognition from many consumers that they were too far in debt.

One of the curiosities in the figures is that hotels and retailers have reported a 0.7% growth in spending, which is puzzling in light of the switch to savings. However, that people are paying down debt is positive, but a question remains as to where those that are saving (rather than paying down borrowing), may be going. With low interest rates, are savers taking large risks?

The remainder of the news is not so positive. The latest rating agency to express concern about the fiscal situation of the UK is Fitch:

International ratings agency Fitch on Tuesday urged Britain, amongst other nations, to put forward "more credible" plans aimed at reducing state debt or risk "pressure" to its top credit ratings.

The UK is rated 'AAA' by Fitch, meaning the agency has the highest confidence in their ability to repay borrowings.

Fitch said in a report published on Tuesday that "all major 'AAA' sovereign governments need to articulate more credible and stronger fiscal consolidation plans during the course of 2010."

Fitch added that such action was necessary "to underpin confidence in the sustainability of public finances over the medium-term and the commitment to low and stable inflation."

Should the UK be alarmed? According to an article on the BBC, the UK should not:

No wonder leading credit ratings agencies have expressed concern and suggested the UK's AAA rating - reserved for only the very safest borrowers - is under threat, sparking widespread hysteria in the media that UK debt is spiralling out of control.

Reading some headlines, you might even be forgiven for thinking UK plc is on the verge of going bust.

But are the UK's debt levels really that bad when compared with other leading developed economies?

The article goes on to show a chart, which identifies the high level of debt in other developed economies, as if this were to suggest that UK debt levels are OK. It is a curious argument that is put forward in various forms by many commentators. It is like a person who is about to go bankrupt pointing to their neighbour and suggesting that their neighbour has borrowed even more than themselves, so that means that they will not themselves go bankrupt. Of course, their neighbour might be earning more in relation to their debts, might be better able to cut their expenditures, might have borrowed from family rather than the bank and so forth. Also, there is the possibility that their neighbour will go bankrupt too. It is, in other words, a simplistic and complacent point of view.

The concern for this post is that the growing fiscal deficit goes alongside the ongoing fall in GDP.

Britain's economy shrank by 0.2pc in the three months to September, more than the 0.1pc decline expected, as stronger construction output was offset by a weakening in the services and industrial sectors.

This leaves Britain officially mired in recession, unlike most of its major trading partners, even though the previous estimate had shown a bigger 0.3pc GDP contraction.

Regular readers will be aware of the fact that GDP includes debt based activity, so it is apparent that the record levels of government borrowing are still insufficient to prop up the GDP figures. Such an outcome is quite shocking, and suggests that the underlying state of the economy is truly dire. The key question is to ask what GDP might look like without the government's huge borrowing, and the word 'ugly' comes to mind.

As for the policy of Quantitative Easing (QE - printing money to finance government borrowing), there is considerable discussion of the policy coming to an end:

All but one of the 53 analysts in a Reuters poll reckon the Bank of England will halt its quantitative easing programme when the current 200 billion pound ($320 billion) asset purchase fund, intended to help keep credit flowing, runs out in the next few weeks.

I am not so confident. As I have previously asked, who exactly will pick up the slack if the Bank of England ceases purchases of gilts? The Bank of England has expressed concern about the state of the fiscal deficits, but that is a long way from a decision to throw the gilt markets to the wolves. This is not to excuse the Bank for an irresponsible policy, but rather an acceptance of the dilemma that the Bank is facing. On the other hand, with the fig leaf of the deflationary fear receding, how might the Bank justify an ongoing policy of QE? I would guess that there are some strained meetings taking place between Alastair Darling and the Bank of England.

The scope of the problems of QE and the fiscal profligacy of the government are now having an impact on the gilts market, with yields on gilts moving to levels that are now comparable with Italy. Even mainstream economists are starting to accept that the policy of QE increasingly looks like a method of monetization of government debt, and that this will eventually lead to a crisis:

In a letter to The Sunday Times, the economists, including Tim Congdon, Patrick Minford and Gordon Pepper, warn of “heightened risk” of a downgrade of Britain’s sovereign debt rating.

The signatories, several of whom are on the “shadow” monetary policy committee, say that the integrity of UK fiscal and monetary policy is at stake because of the huge budget deficit.

They warn that international investors could see the Bank of England’s £200 billion quantitative easing programme, mainly the purchase of UK government bonds (gilts) as “driven by a politically-motivated desire to ease the government’s funding difficulties”

Regular readers will know that I have been making the argument that the QE policy is a method of funding massive fiscal deficits, and that I argued even before the commencement of the policy that the response to a growing fiscal hole would see either printing money or sovereign default. The most incredible part of the entire story is that economists, analysts and commentators have accepted the Bank of England spin on the policy for so long. I suspect history will not be kind to those that have accepted the Bank's line on this policy.

Then there is the 'real' economy. Starting with the banks, they are facing major headwinds, with losses on lending stretching out to the horizon. Commercial property is looking a particular risk, with loans in breach of agreement doubling in the first half of 2009, and expectations for the situation to become worse. Residential mortgage arrears, already at a high rate, also increased in the third quarter of the year by 3%. Some positives might be seen in the figures, even though they are still terrible:

A total of 13,987 properties were repossessed by lenders during the three months to the end of September, according to the Financial Services Authority.

But the figure was 6% lower than during the first quarter of the year, as a combination of low interest rates, Government schemes and lender forbearance helped people to stay in their homes.

The Government has launched a raft of initiatives to help people struggling with their mortgage stay in their home.

[and]

The combination of of Government support, low interest rates and lender forbearance has caused the CML to slash its forecast for repossessions for 2009 by more than a third to 48,000, although this would still be the highest number since 1995.

Of course, the question about such schemes is to ask how much they will cost, and whether they are sustainable, or simply putting off the day of reckoning for both the banks and the mortgagees. With regards to interest rates, if inflation picks up or there are problems rolling over government debt, then it is quite possible that the Bank of England will be forced into interest rate rises.

As for consumer credit, the losses in the coming year are expected to be horrendous, with the following from the Telegraph:

"Economic indicators and feedback from our collections clients suggests that the first quarter of 2010 could be the busiest period ever seen."

Experian is anticipating the worst due to the 771,000 job losses in the first nine months of the year, a 94pc increase on 2008, and the record quarterly personal insolvency rate of 41,390 for the three months to September.

There are a few points to highlight from these indicators. The first is that, with consumers saving and restricting in their spending, it is not clear where the shops, bars, restaurants, and all the other consumption based businesses are going to get their income (the puzzle of growth in spending mentioned earlier). This lack of income will in turn impact upon employment and commercial property, and this will in turn feed into more mortgage and credit defaults, and this will then impact upon the banks. The truth is that, now consumers are trying to live within their means, and are prudently saving, the adjustment can not be stopped. The move of consumers to living within their means can only mean a downward spiral, until the point is reached where businesses supported by excessive borrowing are gone.

Even the government's massive borrowing, acting as the consumer of last resort, is insufficient to hold back the inevitable adjustment - at best it is an expensive mechanism of delay.

Then there is manufacturing. Output is down by 8.4% according to the Economist of 12th December. Bearing this in mind, I read an interesting article in the Times, which was still harping on about the much vaunted theme of the knowledge economy:

The primary question, though, of where the money comes from in the future, is difficult. In 1975 55 per cent of the British economy came from services. Now 75 per cent does. Manufacturing was more than a fifth of the economy 20 years ago. Now it is less than one eighth. But this, in itself, does not mean the economy is “unbalanced”. Manufacturing is roughly the same share of the economy in the UK as it is in France and the US. In any case, outside the aerospace, defence and biotechnology industries, manufacturing is stuck in a trap of low value and low skills. These jobs will migrate to anywhere that adds low wages to the mix.

They still do not get it. This is the bankrupt model that led the UK, and other economies into the mess we are in. A quick look at the current account balance for the UK shows that this has not, and is not, working. Again, according to the Economist, the UK's trade balance is $US -126 billion, and the current account balance is $US -50 billion.

The article in the Times presents the aspiration for a future built upon "biotechnology, pharmaceuticals and sophisticated engineering", but we have heard this mantra in the past, and it is not paying the UK's bills. That winning in these sectors would be a good thing is not a matter of dispute, but the reality remains that the UK has, over a long period of time, failed to achieve this miracle.

Whilst it is possible to point to many successes in the creation of jobs from these industries, it has become clear that the UK also needs to compete in old fashioned manufacturing. The added value in the output in the 'creative' and high tech sectors has not been paying the bills, and this has been hidden by debt based growth. In order for the UK to succeed in manufacturing, the reality is that it must accept the necessity to compete with lower wage countries, a critical element is to remove the burdens on the UK economy associated with excessive government expenditure and debt creation.

A reduction in the size of the state is not the whole solution. A more efficient state is necessary, as is the necessity of pushing for fairer free trade, for example addressing the currency manipulation of China, or the inequities of state intervention in industry in the EU. In addition, there are many areas of the UK in need of reform, and it is beyond this post to detail all of them (see links to my suggested reform at the top left of the page). The point is that the one thing not being addressed by government is the underlying problems at the heart of the UK economy.

Talk of success in high tech and creative industries is easy. Actually generating enough to support a high standard of living in the UK are entirely different matter. History to date has shown us that it is not enough, and there is no reason to think that this will (as if by magic) change simply because people wish it to. The UK has been living on borrowing for too long, and something must change if the UK is to achieve economic success.

For those that point, for example, to the success of countries like Germany, and that we should emulate their policy, I have a simple question. If it was possible to achieve, why is it we have so stubbornly failed to do so? We have had industrial policy and it failed, we have had high government expenditure, and massive state intervention and it failed. Why will it be different this time? Economists might argue about what are the key elements of German success, but can another country - with so many structural and cultural differences - ever hope to reproduce the success? I would argue that the success of one country can not be easily transferred to another country with an entirely different structure and culture. In other words, the UK must enact policy that will work for the structure and culture of the UK.

I read an article recently (sorry, I forget where) which suggested that ongoing falls in the £GB will see trade eventually return to balance. Currency devaluation is often seen as a solution to economic problems, which is partially true. If the value of a currency falls, then the competitiveness of businesses does indeed increase. However, it does so at the cost of relative impoverishment of everyone who holds the currency. In simple terms, if you are paid in £GB and enjoy Belgian beer, then the price of the beer will go up - you are literally poorer in terms of your Belgian beer purchasing power.

As such, devaluation is a solution to a poorly performing economy, but it is a solution in which everyone in the economy is quite literally poorer. It is a mechanism of re-balancing an economy, but it always puzzles me that it is proposed as a 'successful' solution by some economists. It is just a wage cut for everyone, and the erosion of the purchasing power of savings. It is a form of achieving competitiveness that is punitive, in particular for those who have worked hard and saved.

Although devaluation might eventually lead to a re-balancing of the economy, at cost to everyone, the problems of such a devaluation are numerous. As has already been detailed, there is considerable nervousness about the UK's fiscal policy. If a government and the Bank of England seeks the devaluation solution, then there is a real possibility of a gilts strike. If investors believe that there will be an ongoing and substantial devaluation, then it will become ever more difficult for government to borrow, which means printing more money to fund deficits. In addition, inflation will continue to increase, as imports become more expensive. As inflation increases, the cost of government will increase, requiring higher levels of borrowing. I think you can see where this is heading...an inflationary spiral.

Devaluation is therefore a very, very high risk solution. It leaves only one viable solution, which is that the UK economy must just stop consuming more value than it produces. That means that government must follow the lead of consumers and stop borrowing to spend. That the solution will be very hard does not remove the necessity. Yes, the economy will go into a tailspin. Yes, it will need cuts in expenditure in every sector of the economy, even in the NHS.

The basic question to be asked is what is the alternative? A government that lives on printed money, crippling inflation and massive interest payments? Yes, the UK economy might get away with the policy of printing money and massive fiscal deficits for a little longer. But what will happen when this finally unwinds? How much worse will it be then?

As 2009 comes to a close, the deep seated problems in the structure of the UK economy are harder and harder to hide. The (neo) Keynesian solutions that so many supported are now being seen as what they are - a progression towards disaster. The idea that government can borrow and spend to infinity is being tested, and it is apparent that this can only work if people are willing to lend. This small detail escaped the Keynesian economists, who seemed to assume that governments could indeed borrow with no restraint or consequence.

You do not need a PhD in economics to know that people will only lend money if they think they have a reasonable chance of having that money returned to them. You do not need a PhD in economics to know that, if your finances are in a mess, lenders will demand ever more reward for the risk of lending you money. You do not need a PhD in economics to know that you can not continue to live beyond your means forever, and that one day the borrowing will have to stop and paying back the debt will need to start.

Perhaps the most interesting aspect of the coming year for the UK will be the election. It might be that Gordon Brown will seek an early election, hoping for re-election before the economy becomes any worse, or in fear of a coming gilt strike. The likely winner of the election is the Conservative Party, who will inherit an economy and fiscal situation that is on the brink of disaster. To date, the Conservatives have failed to persuade me that they have either the will or the courage to tackle the deep seated problems of the economy head on. Perhaps they are hiding their plans from the public, and do intend a more radical policy than they are currently proposing. This can only be speculation, but in all cases the Conservative Party should be honest with the public.

As the world enters a new year, it is time for honesty. The party is over, and the hangover must now start. When surveying the news, there are still only hints from the politicians of the severity of the situation. The time has come for the politicians to come clean, and tell people about exactly how bad the situation actually is. It is only then that people can actually accept what is an absolute necessity, and that is wholesale restructuring of the UK economy.


Note: That restructuring the UK economy alone is not enough should not stop the process from starting. The more difficult and intractable problems of the world economy must also be addressed, but the UK government can not by itself address this problem. Currency manipulation by China, for example, requires action from the US an the EU.

The importance of ability to service debt.....

I have just been reading a Times columnist, the Business Editor, who is seeking to explain why it is that the UK will not be the next Iceland. The reason why I highlight this article is that it seems to express the profound denial of the reality of the situation.

In his introduction he has the following to say:

The economy is in a bad way and government finances are in an awful state, but let's get a sense of perspective. The City is not Reykjavik on Thames. Britain is not Iceland. Sterling has fallen a long way and may fall further. But Britain is not bankrupt.

The first thing to consider is that the idea that the UK is bankrupt has now gathered enough traction that the subject is now being considered and discussed in the mainstream media. Even six months ago, this would not have been a topic for 'serious' discussion (I have been discussing this for a long while, and this would not have been considered 'serious').

The columnist goes on to point out that, whilst there are some serious problems in the UK economy, they are not as dramatic as Iceland. He then makes the following comparison:

The housing market here may be in a worse state than in America, as claimed by Jim Rogers, the US investor and former partner of George Soros. But the outlook is nothing like as dire as in Spain or Ireland.

The City will go through a terrible time, but the prospects for the German car industry look just as bad.

In this case what we are seeing is something that I have seen through several reports, and even some comments on this blog. This is the idea that country x, country y, country z, are is a worse state than the UK on factor a, or factor b, or factor c.

This is a non-argument. It is a bit like going to a casualty room in a hospital, taking a look at the patients, and saying patient 'a' is okay with his broken arms, because patient 'b' has broken legs. In both cases the patients are not in a good condition. The only way that a reasonable comparison can be made is to compare them to the notion of a healthy patient (i.e. a patient with no broken bones at all).

The columnist goes on to offer this rather extraordinary statement:

By international standards, Britain's government debt is not that high compared with the size of the economy, although the picture does change if all corporate and household debts are included.

In saying this, he is hitting the nail on the head, as the debts of corporations and households in conjunction with large government debts is exactly the point. Every section of the UK economy has been running large deficits. As for government borrowing, one of the oft cited examples is the state of the Japanese governments debt, but the people who cite this forget that much of that debt is funded from within Japan. The problem in the case of the UK is that large tracts of the debt is funded externally, including government borrowing.

We then come to another non-argument as follows:

Standard & Poor's recently reaffirmed Britain's triple A credit rating, just as it was downgrading Spain. And after the mauling the rating agencies have received, they are not in the business of giving anyone the benefit of the doubt.

This is a non-argument on the basis that Standard & Poor, and all of the other ratings organisations have got so much so very wrong, that they should be given very little credence.

Having so far given not a single good argument for the UK not being bankrupt, the commentator then goes on to a complete distraction from the subject at hand. In this case he discusses the problems within the Euro area. The interesting thing is that he should think that the woes of Euro area economies have a bearing on whether the UK is bankrupt. However, he throws in some figures, makes it all look well grounded, and so it all looks very credible.

The only trouble is that it is completely irrelevant to the state of the UK economy. From discussing the troubles of Europe, he jumps into his conclusion as follows:

Britain does not have that alternative to the IMF, but it is hard to believe that we will need it. The hard to believe does happen a lot these days, though.

I strongly recommend that, if you have not done so, you read the article in full. The reason why I am doing so is that this article is fairly typical of the kind of article that can be found claiming that the UK is not bankrupt. When you examine all of the arguments, they always come back to the same method, which is to propose that country 'x' is worse on factor 'a', and figures are then trotted out to support the case.

These arguments are quite simply missing the point. For example, there seems to be a grim satisfaction underlying the collapse in the exports of Germany, and the contraction of the German economy. Last week's Economist was highlighting how quickly manufacturing turned down in comparison to services. In another article (which I can not seem to find) they mentioned how much more resilient services were in a downturn.

What they are all missing is that these economies may suffer now, but they have the means to repay their debts when the global economy starts to recover. As I have been saying for a long time, the UK does not produce enough of value to ever repay the debts that it has rapidly accumulated, let alone the debts that it is adding.

As Jim Rogers, who is now quoted all over the media, has said:

He says his view reflects the UK's dire economic situation: "It's simple. The UK has nothing to sell."

Mr Rogers says the two main pillars of support for sterling have been North Sea oil and the strength of the UK financial services sector, in particular, the City of London's role.

But Mr Rogers says just as North Sea oil is running out, so London's standing as a financial centre is set to suffer: "I don't think there is a sound UK bank now. At least, if there is one I don't know about it."

"The City of London is finished, the financial centre of the world is moving east. All the money is in Asia. Why would it go back to the west?" says Mr Rogers.

This has been one of the central themes of this blog from the very posting. In other words, it is not just a question of comparison of country 'x' on factor 'a', which is always about relative levels of debt, relative state of housing markets and similar arguments. It is also about the ability to pay off debts. What matters is the ability to generate income with which to pay the debts.

As an analogy, we can imagine a person with a £100,000 a year salary job who holds debts of £200,000 and person with a £50,000 salary with debts of £160,000. To look at the absolute debt level would considered to be an unusual method of making a comparison. The only way to look at the debt is to consider the ability to repay the debt, and in the case of the UK that is a very poor prospect.

As a summary, I have yet to see an argument that persuades me that the UK is not in reality structurally bankrupt. Whilst the arguments presented all look very plausible on the surface, they are either comparing basket cases with a basket case, or they are not offering a serious consideration of debt in relation to income.

Note 1: I have had a large number of comments on my last post, and will therefore just have time to answer a few of the comments and questions.

Note 2: Lord Sidcup has the following question:

If the government is printing money and giving it to the banks, but the banks don't circulate it (won't lend) isn't this money irrelevant in causing inflation?

This is a perfectly reasonable point, which is actually quite challenging. Yes, if the government is lending to the banks and the banks are not lending, it would appear that the money will not have an impact. However, the banks do not sit on that money, but are using it to buy government bonds and other so called 'safe' investments to restore their base of capital.

The government then uses the money lent to it by the banks to lend into the banks, and it appears that the money goes in merry-go-round, albeit with the supply of money steadily inflating. This is why the government needs to print more money, to break this cycle, and create a greater impetus to get money into activity in the economy. They are literally going to deluge the banks with so much liquidity that there will not be enough government debt to buy with the money.

The only trouble with this plan is that so many other countries are also selling huge amounts of debt into world markets. As fast as the government might print money, the amount of debt being issued by governments across the OECD will be able to mop up that money. The bottom line is that the banks do not want to lend to business and consumers because they rightly recognise that there are considerable risks in doing so. This is why the government is considering measures to 'force'/encourage the banks to lend into the UK economy, such as reductions in capital adequacy requirements and so forth.

As I have pointed out many times, the problem with government borrowing is that it crowds out lending to the private sector.

In this circumstance, how will the money printing lead to inflation? The printed money is still going to be used but, instead of being used by business and consumers, it will now go through the intermediary of the government, as the printed money eventually ends up back on the government's books through their borrowing. This creates a time lag, as the government must find ways of using that money in various guises of 'stimuli'. There is also a time lag as the money goes through the lending / borrowing merry-go-round.

Within this rather odd scenario is a possibility that the banks in the UK will start to worry about the solvency of the government, and will therefore stop lending to the government. They might instead use the borrowed money only to finance debt of other governments. This is, in principle, possible, but is also highly unlikely. The banks are now effectively clients of the state, so I believe that they will be expected/forced to support the state with continued lending. I do not know this, but I think it is a reasonable assumption.

What we have in total is a situation where some of the printed money will be returned to the government, and some of the printed money will be used to finance the governments of other countries, and some will eventually find its way into private lending in the UK. In all cases, the money will appear in the market place.

If, for example, the banks use money to finance borrowing of overseas governments, this is a net outflow of currency, which will further weaken the £GB. If the money remains in the UK, it will eventually reach the economy in the form of loan guarantees, and various other government stimuli measures. In all cases, the money does eventually reach the market. The important point in all of this is that there is a significant buffer in all of this, which is the ability of the government to actually utilise the money such that it reaches both businesses and consumers in the UK.

The most disturbing part of this scenario is the impact of the government which acts as a buffer for some of the money that is created. In acting as a buffer it is possible in principle that the effects of the increase in supply will not be immediately apparent, encouraging a belief that the government can 'get away' with printing money, thereby further encouraging an acceleration of the speed of the printing presses.

What can not be hidden is that there will eventually be an increase in the quantity of £GB in the market. As I have often stressed, printing money just transfers the value of the existing money to the new money, which dilutes the value of money. This is inflation.

However, I do not think that that people are quite foolish enough to believe that printing money can be a solution to the underlying problems of the UK. This is why I believe that the £GB will collapse sooner rather than later. I do not believe that holders of the £GB will hold on to the currency, as they will start to price in the effects of both the underlying weakness of the £GB and the impact of money printing. At that point, there will be inflationary surges due to substantial increases in the costs of imports.

This brings me to another point. In my original post I pointed out that a collapse in the currency would result in hyper-inflation. I should clarify this, as I have noted comments (not made on this blog) which have imagined that the moment the currency collapses is the moment at which hyper-inflation appears. This was not my intended meaning. There will be a time lag, as existing contracts are fulfilled and so forth. Some products will see price inflation very quickly, such as imported foodstuffs, whilst other products may take a while for prices to inflate. However, the process will still be surprisingly rapid, just not immediate.

It seems that a very short question has demanded a very long answer. It is not a simple answer but I hope I have managed to be clear and consistent. Please let me know if I have been either unclear, or missed any key points.

Note 2: I have had several questions regarding the impact of hyper-inflation on ordinary people. Steve Tierney, for example, asks about the social effects, but that goes beyond the remit I have given myself in this blog. I will let others consider such impacts. However, with regards to the economic position of individuals, this is more within my scope. The problem here is that the question becomes huge, and is not suitable for a brief answer. As such, I will apologise for not addressing this question at this time, and may discuss it later. I also need to look at a few case studies of inflation to have a better understanding, as my concern to date has been where and how we are getting there, rather than what happens when we arrive.

Note 3: ChasH asks the following:

'One thing continues to puzzle me though, and perhaps you can see your way to explaining it. China is our major creditor, but they have been lending us the money to buy that which they have produced. As we cannot repay the money, they have effectively given us the fruits of their labour. Moreover as we (i.e. the west) are their main market they have no one else at present to sell to. Is China then in just as dire straits as we are?'

The answer is both 'yes' and 'no'. China has particular problems, which is the potential for instability, which could see the country fall into chaos.

However, a good way of looking at this is to think of yourself in the position of Hu Jintao. He is seeing that his exporters are collapsing, and that the growth necessary for stability is dropping away. Set against this, he has huge piles of foreign currency, a strong position to spend to support his economy. However, he has a difficult problem.

All the while his economy has been growing, it has accumulated massive reserves of foreign currency. In order to enact a stimulus, he really needs to utilise some of these reserves in order to prop up his economy. However, in order to utilise those reserves, they need to be sold into the market place to buy, for example, the commodities that will be required in support of infrastructure projects. If China starts trying to sell those reserves, he is in a position where there will be a flood of the currencies onto the markets. That flood of currency will depreciate the currency, as there are not enough goods to be purchased in the currency, and likely little demand at this time to use the currency as a reserve. During the downturn, others will equally want to use their reserves to finance their way through the trouble, rather than accumulating greater reserves.

If we look at the $US, if this is sold into the market, and sees the resultant depreciation, then there will be further troubles for exporters. Although the RMB is not a free floating currency, if the $US depreciates, and the RMB does not appreciate, the US will (quite reasonably) howl with rage, and will take protectionist measures. If that is the case, China can say goodbye to one of the major export markets.

In other words, what China has done is accumulate currency that it dare not use as, if it uses the currency, it will destroy the currency. The only solution available will be to try to discreetly sell as much of the currency as it can without 'spooking' the markets.

The trouble is that, with so many countries holding these $US reserves, most of whom have their own economic problems, it is likely that everyone is having the same thoughts, and confronting similar problems. What you have is a situation in which there is something like a Mexican stand-off. As soon as one starts selling, then everybody must start selling. They are all, at the same time, terrified of selling, because in doing so, they destroy the value of what they are selling. It is a time bomb just waiting to go off.

As such, the answer to ChasH is that 'yes', China is in potentially deep trouble, as their best route out of their own problems will create a whole set of new problems. On the other hand, they are also in a position where, if they manage the situation well, they might be able to at least use some of the value in their reserves to ameliorate their internal problems. The question is how much, and whether they can pull off this fine balancing act - using the reserves without destroying them.

Like so much in the current situation, it is apparent that there are real contradictions, and that the situation overall might be described as a mess.

Note 4: I am afraid I have run out of time, so that will have to be the end of this post for today. The answers to the comments are a little rushed, so I hope they make sense.

Note 5: I note no comment from Lemming on my last post, which is a surprise - are you not in agreement with the post? If so, your comments are always welcome, even if critical. Also, I have not seen a comment from Matt in Shanghai for a while. As a person actually located in China, the subject of so much discussion, your thoughts on the situation would be welcomed.

Financing UK Government Debt - The Problems are Starting

I have a comment on my last posting, in which an anonymous poster very kindly provided a link to an article in the Financial Times. I quote from the start of the article as follows:

'The UK and Italy struggled to sell bonds on Thursday in a fresh sign of the difficulties governments are facing because of the debt needed for economic stimulus packages and bank recapitalisations.

The two bond auctions saw both governments forced to pay higher yields to attract investors and Italy scaled back the amount on offer.

Analysts say it is an “ominous” warning that debt raising is likely to become even tougher in the coming months if problems are emerging so soon after government announcements to increase issuance. A record of more than €1,000bn ($1,290bn) of debt is expected to be issued in Europe next year.'

Long term readers will know that I suggested the government would be hitting problems of default about now (as long as six months ago). I have continued in this view, and that means that my prediction was for the default to happen now. However, as you will note from the FT article, we are still at the warning shots stage. The move from warning shots to outright panic is difficult to predict, so it could be an immediate collapse, or might take a while yet.

Meanwhile, as government is going on a borrowing binge, it is worthwhile noting that this has severe knock on effects in the economy, as the government is competing with investment in private business. I discussed the problems that are caused in the wider economy in an article here, but thought it worth mentioning again as I have not discussed the subject for a long time.
If I have my history of economics right (please correct me if I am wrong), I believe that government borrowing (in the modern sense) was started to finance the Napoleonic wars. Regardless of the original purpose it has now become a very bad habit, and one that should really be prevented, by a constitutional constraint if necessary. For the moment, it appears that the problem is about to be addressed by the creditors to the UK, but better the country never got into the problems in the first place.

On a different but related subject, I was catching up on my reading yesterday, and managed to plough my way through the Economist magazine. In an article they discuss the re-ordering of the world financial system, the so called 'Bretton Woods 2'. It makes very depressing reading, as they are proposing that the solution to all of the difficulties is more regulation, and with the wisdom of hindsight criticise the Basel Banking accords (Wikipedia gives a good introduction with Basel 1 here, and Basel 2 here). Again, those who are regular readers will know that I have long 'fingered' the Basel Accords and government interventions as major contributors to the financial crisis. Essentially, the regulation in the banking system created huge distortions in the market whilst giving a false sense of security in the banking system (I discuss this in detail here).

The reason why I mention this is that the lesson being learned from the banking crisis is completely wrong. Instead of accepting that it was the regulation of the banking system that was the problem, the consensus is increasingly that it was the wrong regulation, and that more and closer regulation is the answer. Essentially, the consensus view is that it is possible to take the risk out of banking which, when you think about it, is a very odd idea. The nature of banks is that they lend to individuals, governments and businesses, and some individuals and some businesses do better than others. By nature, whenever a bank lends money, they take a risk.

Now, if we look at Basel accords, they are founded on the idea that different classes of assets have different levels of risk. This means that, for example, a UK issued bond would normally be viewed as low risk, such that banks will be encouraged to lend to the UK government, such that they maintained a balanced risk portfolio. Now, I would suggest that you stop and think about that for a moment.....

We have a system of regulation that encourages banks to lend to a government? Governments are not a productive asset class. They do not do anything to generate concrete wealth. They provide some services, which might be seen as productive activity, but they do not generate income from that activity, they just farm tax from their populace to pay for it. It is a fine distinction. For example, if we go to a restaurant, we pay the restaurant for the service of cooking our food for us. If we pay tax to the government it provides the service of health care. The real difference here is that when the restaurant borrows money, it does so with an expected return, and the restaurant owner/s are risking their own money. On the other hand, when a government borrows money, it is risking the money of the population at large and the money of businesses, with no way of calculating the return on what is borrowed. Furthermore, the business and individuals have no choice but to have the government risk their money for them.

Despite the use of word 'investment' by politicians, this is not the role of government, as their role is spending the money of other people.

So here we have a regulatory system, that encourages banks to lend to government. If they are lending to government, they have less capital to lend into productive activities that actually generate the revenue necessary for government to function. It is rather odd when you think about it.

However, there is something even more disturbing about the whole system of regulation. An inherent part of the system is prescience. Apparently, it is possible to know the future of different classes of investment. For example, the Bank for International Settlements can apparently see the future and determine what is risk and what is not, and national regulators do then do the fine detail of what they will accept as safe or unsafe investments. Amazingly, these very clever people have an insight on risk, and can determine what is a risk and what is not. They must be very clever indeed.

The trouble is that, UK government debt has long been seen as very low risk, but we are now seeing that it is actually very high risk. The trouble is that, over the last 12 months, all kinds of 'safe' investments have proven to be unsafe. Essentially, what you have is a system in which lots of apparently very clever people can supposedly determine where risk resides. However, as experience is telling us, they have absolutely no idea where risk resides.

So now we come to the answer that is being proposed. More clever people will now sit down and re-determine how risk should be calculated, having learned lots of lessons from the recent crisis. All of these very clever people will get together, and once again will strain themselves to see the future, and determine what the future might be. But the trouble is, that is what they did before.....

Essentially, there is no escaping the fact that the world is a complex place, the world is unpredictable, and individuals are fallible and make wrong decisions. No amount of regulation of the banking system will change this. There is no reason to believe that the people who determine the particular risk of asset class have any better grasp of the risk inherent in that class than the holder of that asset - the banks themselves. The simple fact is that, what was safe yesterday, can become unsafe the next day. No one individual, or group of individuals, is infallible, so why should they be able to determine risk?

As such we come back to the start, and have to say that, whenever we deposit money in a bank, we are taking a risk that the bank will lose that money. We need to accept that risk, because we make that risk with possible trade-off that the bank will invest the money and increase our wealth. However, any idea that this can be guaranteed is just foolish, and no amount of regulation will make that guarantee. All such regulation serves to do is create a false confidence, and thereby encourages systemic risk.

What we have now seen is that such guarantees are worthless and, as a result, we have governments having to accept liability for their former guarantees of the safety of the system. However, it is not government that picks up the tab for that guarantee, but every individual and business within the country. In other words, there is a system in which people apparently know better than banks where the risk of those banks reside, they then say that if the bank follows their rules, they will guarantee that all the money invested in those banks is safe, and they make that guarantee with the money of tax payers.

When you think about it, it is a completely absurd idea. However, lots of very clever people all think this is a great idea, and persuade us all that governments offering guarantees (based upon their mystical knowledge of future risk) using our money is a good thing.

Note 1: Thank you all for the comments on energy policy, which were interesting and challenging. I had an interesting comment from HYDROGENPHILE (his caps), who suggested that hydrogen is the answer to storage of energy. This is presumably based upon the use of fuel cells, which are an interesting emerging technology that I have followed for some while. However, until the switch to a hydrogen energy economy is made, this does not address the problem of the here and now. In other words, the switch to a hydrogen economy needs to be made before the investments in energy provision that relies on that switch is undertaken.

UK Government Edges Ever Closer to Bankruptcy

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

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

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

And,

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

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

And,

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

And,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Quite simply, it is a tragedy.

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

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

UK Government on Track for Bankruptcy

Today, I am just going to conduct a very quick review of some of the news that has emerged is confirming the the UK is on course for a government debt default. The strength of the US currency means that the US is safe from default at the moment, but a UK default will probably be the first step towards the loss of confidence in the US government position, and may see the US default as well.

The first piece of news is that the IMF is now running out of funds, and as I have discussed before, the idea that the IMF will be able to rescue the UK when the crisis comes is diminishing. The second piece of news is that the once mighty £sterling is in freefall against currencies around the world. This is what the Times has to say:

'The descent of the pound drew comparisons with the early 1990s. Then it fell 50 cents from $2.01 to $1.50 - but this time the downward spiral of the currency is gathering momentum.

“People are selling the pound because it’s there. There’s no reason for them not to,” said Nick Parsons, head of markets strategy at National Australia Bank, who is forecasting that the pound will go as low as $1.40 early next year.'

The most interesting part of the article, however, is that the reasons for the fall, which are given as:

“We will go down further because the problems the UK faces are worse than other countries. We are uniquely exposed because of the sheer amount of debt we’ve got.”

In other words, the markets are now realising that the UK is in very deep trouble, and that the UK debt position is unsustainable. This has been an underlying theme of the blog since the first post. The collapse of the £sterling is exactly as predicted in my November essay 'A Funny View of Wealth':

All the while this is happening the government will fall into crisis. With a falling pound, an economy collapsing around them, and an already overstretched borrowing position....'

The 'all this' that I am referring to is the collapse in house prices and consumer spending, and the downward spiral of the economy. I detailed in the essay why the £GB would fall. One factor is the collapse in inward investment that bolstered the £GB, another is that the UK simply does not produce enough goods and services to support the £GB. To this, in later posts, I added that demand for the £GB would fall due to drop in demand for the currency to lend back to us.

The implications of the fall in the £GB for the UK economy are profound. The problem that this will cause for the government will be how to finance government borrowing. With a falling £GB the UK overall is now a high risk destination for money. Nobody wants to lend into a devaluing currency, as the devaluation destroys the value of their investment. This will drive lenders in one of two directions; either they will charge extremely high costs for their lending, or will ask for repayments in another currency, thereby shifting the risk on to the borrower. In both cases, government borrowing will become unaffordable.

Meanwhile, government spending is already spiralling out of control. Add to this that the government has now taken on huge costs and liabilities in the banking bailout, and it becomes apparent that the government is on course for disaster. For example, according to the Times, repossessions have climbed by 71%. The collapse of the economy is going to see ever more defaults on mortgage and consumer credit, as well as defaults on consumer loans. These defaults will hit the financial sector hard, and that now means that they will hit the government. The government is going to need very deep pockets to support the financial sector, but it just does not have them. This is one of the reasons why I have consistently opposed the bailout, arguing that it would push and already overstretched government into the certainty of default.

As the crisis deepens, the government talks more and more of ever more borrowing, calling on the ghost of Keynes as justification. However, Keynesian economics never allowed for increased borrowing in the 'good times', and in the case of the UK the borrowing has been both by the government and consumers. In other words, even if Keynesian economic theory is accepted, this is a gross distortion of the principles. There is therefore no doubt that very few potential investors are going to buy the UK government's economic policy.

For lenders, there will be a larger question looming. How exactly will the UK emerge from this crisis, and how will the economy expand to eventually repay this borrowing. I posted a comment on a forum a while back, asking anyone to point to where the future growth to repay the debt will come from. Not one answer was provided, and this is because there is no miracle around the corner that can return the UK to wealth. There are, quite simply, no sectors of the economy that promise any growth that will provide any significant new real wealth.

All of these elements add up to the onset of the financial crisis for the UK government, and a sovereign default. It is now only a matter of time before the UK faces up to the reality. It is bankrupt.

Note: I have been asked to give a firm date (see comments below) for when the UK will default on debt. However, whilst I have predicted the timing of many of the key events of the current crisis, this does not mean that I can read the future. I first mentioned the possibility of UK defaults back in June (I believe) but gave no estimate of time. More recently, I have suggested that it would be in about 3 months time, and that was about a month ago. I believe that the guess is starting to look more ever more credible, so will stick with that timescale, so would guess at about 2 months time. However, this is no more than a guess, as the determinant is going to be something that is hard to predict - confidence.