The UK Mid Year Budget Statement

The mid-year budget statement has prompted concerns about the UK economy. It is a classic case of 'incrementalism' and fiddling. For example, see here for benefits reform and the silliness of framing the limited reform with the discussion of 'Mummy Tax'.

This is gloomy pre-statement commentary from Alexander Heath in the Telegraph:

Psychologists call this cognitive dissonance; unkind folk would see it as plain cowardice. What is clear is that such self-deception has reached epidemic proportions when it comes to the economy, and has contaminated all major political parties as well as many professional forecasters.

In the absence of shock and awe supply-side and tax reforms, which are not on the cards, our long-term growth prospects are bleak. George Osborne’s greatest problem, as he prepares to deliver the Autumn Statement, is that the British economy is stuck in a rut.

He has grasped something of the reality. In the UK, we are now starting to see something of the negative spiral that follows in the wake of attempts to incrementally cut government borrowing growth in the face of an economy that is structured around servicing the growth in borrowing (sorry, for the convoluted sentence). However, this from the WSJ:

The U.K Treasury painted a grim economic picture, acknowledging that growth was weaker than the government expected and that a tough austerity plan would drag on longer than planned.

Treasury chief George Osborne, who presented his closely watched twice-yearly economic update Wednesday, delivered a triple whammy of bad news. He conceded the economic recovery was taking longer than expected; that he would likely fail to meet a key self-imposed debt goal; and that government cost cutting would continue until 2018, three years longer than initially planned. At that point, the U.K. will have experienced eight straight years of austerity.

Mr. Osborne and the Conservative-led coalition government is halfway through its five-year term. Having come to office promising to fix Britain's weak economy, Mr. Osborne is under immense pressure to demonstrate that his strategy is working ahead of the next general election, due 2015.

Except for the misuse of austerity, it is a reasonable summary. The pressure is no doubt building to get the money printing presses running again:

Sterling edged up from one-month lows against the euro on Wednesday after a gloomy UK budget statement which traders said was in line with expectations.

But forecasts from finance minister George Osborne that Britain would miss its debt-reduction and growth targets left the currency looking vulnerable.

Analysts said the poor UK economic outlook might revive prospects of more monetary easing by the Bank of England and increase the risk of a credit agency cutting the UK's top-notch rating, both of which would be negative for sterling.

 The OBR is taking a negative view, saying that:

The independent Office for Budget Responsibility predicted the UK economy would shrink slightly this year and grow less over the next four years than it had forecast in March. Robert Chote, chair of the watchdog, said: "What's striking is the weakness of the recovery over an extended period of time."

I hope that, for regular readers of this blog, that the 'weakness of the recovery' is in fact unsurprising, and that they already realised that the UK economy has only now just started an unavoidable process of shrinkage i.e. any economy which is structured around servicing debt growth cannot shrink the debt growth without negative consequence. Worryingly, the current state of affairs is leading to threats to the UK credit rating:

The chancellor's statement did nothing to dispel fears that the UK could be stripped of its triple A credit rating. Both Moody's and Fitch, two of the three major rating agencies, put negative outlooks on the UK's rating this year.

Whilst the ratings agencies are generally hopeless, they are still important. They make a major difference due to their role in banking regulation and their pronouncements have real impacts. I seem to recall that George Osborne placed the credit rating of the UK as one of the drivers for his policy, so any significant downgrade would certainly add to the pressure now being placed upon the government. This is Bloomberg's view on the mid-year budget statement:

In lieu of real change, he proposed a set of well-intentioned but ultimately insignificant policies, restricted by the need to make the package as a whole fiscally neutral. Osborne did not need to be this cautious.

The chancellor did act to redirect government money in a few ways likely to produce growth. He said he’d reduce the nominal rate of corporation taxes to 21 percent from 24 percent in 2014 (compared with 35 percent in the U.S.). He also increased by a factor of 10 the amount of capital investment that U.K. companies can make exempt from taxes each year, to £250,000 ($402,300) from £25,000.

Osborne scraped together £5 billion to spend on schools, transportation, and flood defenses. He also set up a body to eliminate the regulatory gridlock that’s blocking development of shale gas in the U.K. and promised tax breaks for exploration, ahead of a new policy aimed at increasing Britain’s production and use of natural gas. These are all intelligent ideas that may boost construction and employment in the near term, and growth in the longer term.

I am inclined to agree that there was no real change, but suspect that, if shale gas lives up to its promise, then this will have very significant impacts through the potential to lower energy costs; a factor in living standards but most importantly in the cost of manufacturing. However, this will not really have any major impact for several years, and before it will be a positive contributor to a more competitive economy and better living standards. In the short term, there may be a small impact through increased investment, with the activity that follows from this, but it will not be enough to significantly lift the economy. As such, although a positive, it does little to address the problems in the short term.

Nor will the rest of the measures. The problem that will now face the government will be the political pressure to reverse course. For example, I disagree with Bloomberg's view, which is inevitably echoing around the media, that the government should give a 'modest boost' to the economy by relaxing budget constraints. The one thing that the government should not do is relax on this issue.  
Regular readers will know my answer is to take more aggressive measures on government spending, at a cost of short term pain, in order to avoid a worse situation in the future. However, I accept that the real pressures mounting for the government to loosen will make this nearly impossible at this moment in time.

As a pragmatic compromise, instead, the government should follow what is (in some respects) sometimes good advice, but which is given as advice for the use of additional borrowing (i.e. the projects will increase borrowing). Rather than funding through additional borrowing, those projects which address genuine problems in infrastructure should be given as a priority but as a priority that displaces current levels of spending on consumption based services provided by the government. 
In other words, the government should cut spending to fund investment (and I mean investment in the sense before the distorted use of the word as a synonym for government spending). Where there is genuine need for certain types of infrastructure (and I here accept the current reality that government will fund this), it is a better way to use borrowed money than borrowing for consumption.This will require cuts in services, and the answers I give on how to cut remain the same.The answer is to ask which services are a priority, and then to make choices according to the priorities.

In my mind, this is best achieved by asking the question of whether service x or y is really the role of the government, and cutting anything which is not a core government function. It is a question of 'luxury' over 'necessity'. The economic question is 'what can the UK afford?' but the answers as to what is necessity and luxury are political questions. The other answer is the one that I have discussed previously in my sections on reform. Having established the priorities, how can they be delivered in a way that is cost effective, but also hold to the principles on which they were established? As an example, I have proposed reforming benefits, such that there is still a (generous) safety net for those who are confronted by bad luck / unexpected difficulties, but where the costs of the system are minimised.

As the situation stands, the UK is continuing down a road which does not address the fundamental problems of the UK, with reductions in borrowing growth that will not address the underlying economic problems, and without the kind of substantive reform necessary to lay a real foundation for economic recovery. I believe that I long ago expressed the concern that the UK government would try to resolve the UK's economic problems with incremental cuts and policy measures, and this is exactly the path being followed. The trouble with this approach is not just that overall debt continues to grow whilst the economy shrinks, but also the problem is that the inevitable contraction in the economy leaves the government open to pressure to reverse course mid-term. It is, in summary, self-defeating even when taking a political perspective.

I can never make up my mind what prevents the solutions that are possible to help resolve the problems of the UK economy; is it lack of courage, political consensus or lack of imagination, or the economists whispering 'easy' solutions in the ears of politicians. Perhaps it is all of them. I started the post with Alexander Heath's article, and who proposes cowardice; in light of the self-defeating nature of incrementalism, perhaps he is wrong? Perhaps it is just lack of imagination?

Oh dear, Prof. Krugman

This is a very short post. This from the Guardian on the ever more odd discussions of Prof. Krugman:

On the day the Nobel prize for economics was announced in Stockholm, a former winner was in London urging the government to ditch the "mad" austerity policy that was keeping the British economy depressed. Paul Krugman joined Jonathan Portes for a debate on whether the government had gone too far, too fast.

In what world is the current level of government spending 'austerity'? It is the oddest idea that can be imagined. The deficit is huge (from the Guardian):


Apparently this is 'austerity'. Or at least according to the ever more unreal Prof. Krugman this is 'austerity'. Nevertheless, his words will be taken seriously by many. He may have won a nobel prize, but that does not make his pronouncements any more sensible than any other of the many economists that failed to recognise the problems in the world economy until they were already in plain sight.

The UK Economy, the Euro and the Least Ugly Contest

I have, for a while, been focused on the Euro crisis, and I will not be the first to note that, as the UK's largest trading partner, the Euro crisis is set to have an impact upon the UK. It is therefore unsurprising that David Cameron (and also notably Barack Obama) has argued for Germany taking more direct action to support the Euro, in particular as it is Germany that is in the front of the line to pay the bill. Jeremy Warner of the Telegraph speaks for many when he says:

The stand-off got a whole lot worse this week. France and Germany are now in open conflict over the way forward, if indeed there is one. For the UK, already bleeding badly from the after-effects of the financial crisis, the situation could scarcely look more threatening.

 The fiscal consolidation chosen by the Coalition was always likely to have a negative impact on output, at least in the short term. To make it work, the Government needed the following wind of decent growth elsewhere in the world economy. Instead, it’s facing a hurricane. We look set to be broken by the storm.

There are no end of commentators expressing their thanks that the UK is not in the Euro, so I will not add to these. However, in response to the Euro, of particular interest is that Bank of England is yet again likely to go down the road of further quantitative easing (printing money). This from Reuters:

Evidence that both may be needed was sharply underlined by data showing that Britons have been shopping much less and factories getting far fewer orders.

In minutes of its May meeting, the Bank of England reported that while 8 of 9 policymakers voted to end a 325 billion pound round of asset buying to keep interest rates low, they had not closed the door on more.

Separately, Deputy Prime Minister Nick Clegg said it was an "absolute priority" to get credit into the economy and pledged to "massively" amplify what the government was doing in its 20 billion pound credit-easing scheme.

Both echoed a prescription delivered on Tuesday by International Monetary Fund head Christine Lagarde, who urged the central bank to buy more assets - possibly including company bonds and mortgages - and called on the government to find money to boost infrastructure spending.

Longstanding followers of the Bank of England's policy of printing money will undoubtedly recall that the policy was put in place with the justification that it was a unique circumstance that drove the policy. As has now been reported ad infinitum, the Bank of England long ago lost all credibility with regards to their original excuse of using money printing to prevent deflation. It now seems that, whatever might produce headwinds for the UK economy, the printing presses will start rolling. What has become an exceptional policy is now becoming routine policy.

We can see the same phenomenon in the US, Europe and Japan. There are two possible interpretations for the 'routinisation' of printing money; the first is that policy makers actually believe that it works, and the second is that they are now completely bereft of any idea of how to fix the ongoing economic problems.I go with the a mix of these two interpretations. For the former, I am guessing the Bank of England aim is a defensive attempt to pull down the value of sterling, out of fear of the impacts of a strengthening of sterling against the Euro. However, as an offset to this the resultant low interest rate will only encourage further borrowing, with potentially negative impacts upon the current account balance (see later, and chart below for the current account balance from ONS).

I have previously discussed flows of capital as a least ugly contest. Investing is no longer a case of looking for attractive investments, but trying to find the least unattractive.There is a catch, though; whilst investors may look for the least ugly, sometimes it pays for countries to be a little ugly. This pulls down the exchange rate, and this in turn helps to maintain a competitive exchange rate (regular readers may recall my example of Switzerland some time ago). Printing money might help with this, but the problem is that it is becoming a universal solution to trouble; right now, nobody wants their currency to appreciate and competitive devaluations are a real possibility. As it is, the UK economy is looking rather ugly without any further money printing:

The U.K. economy shrank more than initially estimated in the first quarter after construction was revised to show a deeper slump, which may bolster the case for the Bank of England to restart bond purchases.

Gross domestic product fell 0.3 percent, compared with a 0.2 percent decline estimated last month, the Office for National Statistics said today in London. Construction output fell 4.8 percent, the most in three years and more than the 3 percent initially estimated, while services and production were unrevised. Net trade and inventories subtracted from GDP.

I say 'rather ugly', as it must be remembered that this decline is still taking place in an environment of massive fiscal stimulus, with UK  government borrowing and spending supporting the economy at the cost of an anticipated deficit of £120 billion for the year 2012/13. There is no austerity anywhere in sight, and yet the UK economy is showing declining GDP. What is, in fact, taking place, is a slowdown in the rate of borrowing, as can be seen below (from the Guardian).

 

It is notable that this excludes financial interventions, which is the government's 'preferred' measure. More worrying is the cumulative total of debt being accrued, with the UK debt clock providing a graphic representation of the growth in debt.The Daily Mail provides a good summary of the current situation of debt in the UK, and it extends beyond concerns about government debt (I do not usually cite the Mail, but they are using some good sources):

There's also the not-so-small issue of Britain's household consumer debt problem which, in relative terms, is the second worst in the developed world.

They have a point. I checked the latest statistics from the Bank of England, and it sees a slow month on month climb in consumer debt. This helps to explain small increases in consumer spending even whilst real income is in decline. Again, from the Mail:

But there's also a misconception about consumer debt. There's much talk of businesses and households 'deleveraging' - paying off debts.

But in reality, Britons are not paying off what they owe. There were hopeful signs of this happening when mortgage rates fell sharply in 2008 and 2009 - some borrowers used the opportunity to pay extra off their mortgages. But consumers soon returned to form and began borrowing again to spend.

Even the falls there have been are due to banks writing off debts, according to the campaign group Save Our Savers (SOS). It points out that total consumer debt stood at £1,461billion in November 2008 and £1,452 billion in November 2011. But banks wrote off £26.7billion of consumer debt. So excluding the bank write-offs debt actually rose by £18.4billion.

Credit card debt continues to 'run rampant', says SOS, rising from £53.3billion to £56.5 billion over that time even thought an 'extraordinary' £13billion has been written off. Total credit card debt when write-offs have been stripped out has exploded by £16.1billion.

So the clear picture is that debts are not only still rising, by bad consumer debts are also just shifting across to become financial sector company debt which, if recent history is anything to go by, could one day become state debt.

And the projection, is that UK debt is set for another explosion. According to the Office of Budget Responsibility, personal debt will grow by nearly 50 per cent from £1.5trillion today to £2.12trillion by 2015.

More interesting than any individual sector is the overall picture of debt, and the graphic below paints the picture by including government, retail, financial and business debt.

These figures should be a cause for worry in all circumstances, but become even more worrying when seeing the UK balance of trade and current account. This from the ONS:

• The UK’s current account deficit was £15.2 billion in the third quarter of 2011, the highest on record.
• The trade deficit widened to £9.9 billion in the third quarter of 2011, up from £7.2 billion the previous quarter.
• The income surplus was £0.3 billion, the smallest surplus since the fourth quarter of 2000.
• The financial account recorded net inward investment of £22.0 billion during the third quarter of 2011.
• The international investment position recorded UK net liabilities of £245.5 billion at the end of the third quarter 2011

This is a chart of the trade balance from the ONS:

 

 A quote from the explanatory note on the chart is given below:

The trade in goods deficit increased to £27.6 billion in the third quarter of 2011, the highest on record. Exports increased by £0.1 billion to £74.2 billion and imports rose by £2.7 billion to £101.8 billion. Both exports and imports are the highest on record.

In crude terms, UK borrowing and spending is a good way to help other countries export goods and services to the UK, and in particular goods. Sure, it increases activity in the economy, as distribution of the goods and services creates activity. However, this cannot be sustained forever. Whilst this has been the case for many years, there must come a point at which borrowing can go no further, and the earlier chart from the Mail highlights that the UK is now reaching a point where the unsustainable nature of the borrowing is becoming very apparent.

I return now to the question of the Euro crisis. As the situation stands, the situation in the UK has been continuing to deteriorate, despite talk of austerity and living within our means. Borrowing and spending is ongoing, and the UK is still consuming more than it can produce. Nothing has really changed since the onset of the financial crisis, excepting that the total volume of debt has increased, and is increasing. No real reform of the UK has yet taken place and the current account figures tell the real story.

Notwithstanding the lack of substantive action so far, the government appears to be genuinely seeking to reduce the rate of debt accumulation and, if it succeeds, as I have argued many times, this absolutely will see a fall in GDP. I have never accepted the absurd idea of expansionary austerity. However, as the earlier chart of total UK debt shows, austerity is a necessity as debt levels become unsustainable. Again, regular readers will know that I do not accept GDP as representing a useful measure of the economy, as GDP figures include activity from borrowed money. However, many take GDP seriously, and as GDP declines, the UK economy will start to look a little more ugly. In short, even without the Euro crisis, the UK was set to become uglier.

To add to these concerns, we have the accelerating Euro crisis and, on top of this, if the Bank of England prints more money, this will add a little more to the ugly factor, albeit partially offsetting this by possibly (temporarily) shoring up GDP figures. The question that this raises is how the UK will look overall in the least ugly competition. I would argue that, so far, the UK government has managed to convince the world that it is not so ugly and have done so with with the promise of future action. That action is now commencing, and doing so just as a shock is about to hit the UK economy in the form of the Euro crisis. The UK economy, as I have outlined, is in no state for this kind of shock, and the fallout of the Euro crisis will combine with the impact on GDP of genuine moves towards austerity. It is not a pretty picture. The UK may become very ugly.

The only possible offset is how ugly other economies will look as the Euro crisis accelerates, and this might allow for some kind of reprieve. In other words, the confidence in the UK economy will be measured by its relative ugliness to other economies. How ugly those economies will be will only become apparent as the Euro crisis accelerates. Perhaps the UK may yet survive a little longer in the least ugly contest, if only because some of the other contestants are going to become so very, very, ugly. Only time will tell, and whichever way this runs, the UK is heading for some very tough times.

Note 1: I assume here that the Euro crisis will not be resolved. I would never say that a resolution is impossible, but it becomes less and less probable as each day passes.

Note 2: I was hoping to respond to comments, but this took me far longer than anticipated. As such, please accept my apologies.

Anti-Austerity in Europe

I watched the outcome of the French election with considerable interest. It seems that anti-austerity is becoming a major force in Europe. Even more interesting is the collapse of the will for austerity in Greece.

It is a quite fascinating situation, which is also quite alarming. It is fascinating as the 'Krugmanesque' vision of economics may finally be put to the test. That is, it seems that it may now be the case that the borrow and spend spigots will open for already 'in trouble' economies. As regular readers will know, I do not deny that borrow and spend will indeed create employment. After all, it is not difficult to spend somebody else's wealth on make-work activity or paying for activities that would otherwise not be affordable. I do not deny that this will create more tax revenue. If more people are working, and more are spending, then indeed this will indeed create the activity in the economy that will garner greater tax revenue. Likewise, this increased activity will appear to either slow economic shrinkage, stabilise, or even grow an economy.

The problem is that it is very, very easy to spend the wealth of others in generating activity. The problem is that this borrowed wealth will eventually need to be returned to the lender. This in turn generates the problem that, if people doubt the borrower's ability to repay, then they will not lend. The question then arises as to whom, exactly, these want to be borrowers might actually borrow from. It is all very well for people to march on the streets and demand an end to austerity, but they are demanding that governments spend money that they do not have. However much these marching/protesting individuals and their political leaders demand borrow and spend, they have a problem. The problem is simple. They simply do not, within their own country, create the wealth that they desire. That is why they must borrow.

The wealth that is desired by the protesters and their political leaders only exists external to their own economy. It is not theirs, and short of going to war, they can only access this pool of wealth if the holders of the wealth choose to allow access to it. No amount of protest, political rhetoric, demands, tantrums and so forth, will change this.

Of course, there is always the possibility of raising taxation in a country to pay for all of the government spending. It is always possible to squeeze the pips out of the wealthy. Or at least, as long as the wealthy hang around to be squeezed. However, the term capital flight is not abstract; there comes a point at which people feel that the redistribution of their wealth to others is unacceptable, and they will choose to remove their wealth to a place where such a redistribution will not take place.

Even if accepting that the wealthy can be squeezed, the 'in trouble' economies will have to squeeze very hard  to make up for the loss of borrowed wealth from external sources. And that is the problem; even if increasing taxation for the wealthy, will governments be able to manage without the borrowing of external wealth to pay for all of their reinstated/increased spending programmes? I mean really; can this do the trick? I very much doubt it. 

The plans of the anti-austerity movement are quite remarkable. They are remarkable in that they assume that there is some hidden source of wealth that is the right of their country. They do not have, or produce, this wealth themselves, but are apparently entitled to it. If the anti-austerity movement wins out, we will be able to see whether the Krugman approach actually really works in practice. I read recently that Krugman's view is influencing political leaders in Europe; that his proposed remedies are believed to be the solution.

Of course, there is nothing to say that some of the 'in-trouble' economies might not borrow a bit longer. For a while at least, the Krugman solution may appear to work, and encourage others to speak out/act against austerity.The success of anti-austerity will, if this takes place, be trumpeted as a solution - at least up to the point that the lenders of wealth lose all confidence. As an analogy, think of the Jurassic Park films; there is a sequence in which the lead character says something along the lines of; 'That's how it always starts, with the oohs and aahs, but then the biting and the eating starts'.

So, if the anti-austerity movement wins for a while, those in favour of the movement will sound out their 'oohs and aahs', but when all confidence is lost, the picture will change dramatically. It is quite possible that we are about to witness a real world economic experiment, in which the theories of individuals such as Krugman will finally be tested. They believe that wealth can simply appear by borrow and spend/tax and spend. They believe this will create a virtuous cycle that will fix economies.

I, on the other hand, believe that wealth is, in the end, created by creating a framework in which individual endeavour creates real wealth. This individual endeavour, whether from a bricklayer or a the CEO of a multinational, is the real source of wealth creation. They make products and services that people want, and can pay for the goods and services as a result of their own individual endeavours. The relative success of these individual endeavours, in aggregate, in terms of productivity, and in relation to other countries, determines the real wealth of a country. Not borrowing.

I suspect that we are about to find which vision of economics is correct. I hope I am wrong. If I am not wrong, then the outcome may be very disturbing.

The Greek Crisis

I don't know about the readers of this blog, but I am now at a stage of simply being overwhelmed by the ongoing and endless rescues of the Euro. Every day the news pours out on the latest initiative, the latest plan, the latest crisis meeting/summit, the latest bad news......In light of this, it was a pleasure to read the latest take on the story from Spiegel Online, which cuts through much of the fluff on Greece. The headline and sub-head offer a great summary:

European Politicians in Denial as Greece Unravels


Europe's politicians are losing touch with reality. Greece is broke, and yet Brussels wants to send the country billions in new loans, to which there is growing opposition within the coalition government in Berlin. Rescue efforts are hopelessly bogged down by bickering over who will ultimately step up.

This was the part that I really liked:

The Greek economy is not productive enough to generate growth. Aside from olive oil, textiles and a few chemicals, there are hardly any Greek products suitable for export. On the contrary, Greece is dependent on food imports to feed its population.

"Greece has been living beyond its means for years," an unpublished study by the German Institute for Economic Research (DIW) concludes. "The consumption of goods has exceeded economic output by far."

Especially devastating is the assessment that the DIW experts make about the condition of an industry that is generally seen as a potential engine for growth: tourism. According to the DIW study, the Greek tourism industry concentrates on the summer months, with almost nothing happening throughout the rest of the year. There is almost no tourism in the cities, which translates into low overall capacity utilization and high costs for hotel operators. By contrast, capacity utilization in the hotel sector is much more uniform in other Mediterranean countries.

I have long argued that this is one of the fundamental problems that sits beneath the economic crisis. It is the fantasy that a country can just continue to endlessly consume more than it produces. Whilst Greece may be an extreme case, it is very apparent that Greece is not alone. I am going to quote at length from the first post of this blog, which is from an essay I wrote in 2007:

I am going to start by looking at the world from the point of view of many modern economists. Whilst none of the economists would accept that what I am about to portray is their belief, when you look hard, you will find that this must be their basic belief. If not, then they have no justification for their pronouncements of success for the UK economy.

Imagine a family living in the UK, not an atypical family, not a typical family, but an ordinary middle class family. We will call them the Wilsons. The father has a job in management for a chain of retailers, and earns £30,000 per year. The mother has a good job in a local hotel where she is the marketing manager and earns £30,000 per year. They therefore have an income of £60,000 a year. They have two children at the local school.

The Wilsons have purchased a home, which cost them £300,000, which is five times their combined income, using a 95% mortgage. The house has increased in value by £30,000 a year, in each of the three years since they purchased it. They are very pleased to see their house growing in value, as it is like having another earner in the house, except this earner pays virtually no tax on the income, making it an even better earner than themselves.

The Wilsons have a relatively large mortgage, but interest rates are low. Despite this, they struggle to balance the quality of life that they enjoy against their income. As such, they make use of credit cards to occasionally purchase items. Each year, for three years, they have added £6000 to the family debts through overspending on the ‘little luxuries’ in life, such as holidays, and new goods for the house. At the end of the second year in the house, Mr. Wilson decided that he would fulfil his dream of owning a Mercedes, and re-mortgaged the house to realise £20,000 of the increase in value of this asset. He used this as the down payment on the car, and took a loan for £20,000 to pay for the remainder.

Overall, the Wilsons non-mortgage debt stands at £18,000 for the credit cards, and £15,000 remains of the loan for the car. They are starting to find the payments on these debts are stretching them, and they seem to be using the credit cards a bit more often than before.

Next door to the Wilsons live the Jones family. The Jones family know and respect their next door neighbours. They can see how successful they are. They are always doing something to the house, making improvements, and they seem to be living the good life. Only recently the Wilsons bought a new Mercedes and Mr. Jones feels a little jealous, as he would love a Mercedes too.

The Jones family, have less income than the Wilsons, but every year they save a few thousand pounds. They have no debt except for their mortgage, and only spend what they earn. They purchased their house at the same time as the Wilsons, and are steadily paying their mortgage. Their belts are tight, but they get by, and look forward to better days ahead.

Which of these two families is the more wealthy family?

The answer largely depends on whether you are an economist who has been a cheerleader for the boom of the last ten years, or whether you are a person grounded in the real world. The Wilsons have been the motor of growth in the Anglo-Saxon economies. Apparently we have gone through a period of sustained growth and, in moments of hubris (Gordon Brown in the UK being a wonderful example), we promote the ‘success’ of the Western economies to the rest of the world. The trouble arises when we ask a simple question; ‘Where is this growth?’

The Greeks are the Wilsons. Yes, they have lived a good life. But the bills have simply grown to the point where they do not have enough income to repay them. This aspect of economics has never been complicated. If you are continually borrowing to pay for consumption, you will indeed have a high standard of living - for a while. Unless your income growth is outstripping the rate of debt accumulation, it is only a question of time before the credit becomes too much to service. It is not a case of 'if', but 'when'.

It is very curious how much effort and time goes into denying this simple formulation. The answer to the problems of too much debt is apparently to just borrow more....We see it endlessly from economists, politicians and commentators. Austerity is self-defeating. The answer is to borrow more. 'Yes', when borrowing more, the economy will appear to grow. Just like the Wilsons, there will be an illusion of wealth for a little longer. However, like the Wilsons, it can not change their actual real income; it cannot change the ability to create real wealth.

The Spiegel article gets to exactly this point with Greece. Greece simply does not have the ability to continue to have the high standard of living that it has previously enjoyed. That standard of living was supported by unsustainable debt accumulation. They just do not create enough wealth to either continue to live as they have done, or pay back the debts accumulated in giving them an illusion of wealth.

I just do not understand how it is that this simple and evident reality can be ignored by so many. In the case of Greece, it is plain to see. And just as it is plain to see in the case of Greece, it is also plain to see in the cases of other economies. They may not be as dramatic as Greece, but the same principle applies.It really is very simple.

Austerity in the UK

I know I bang on about Krugman, but his pronouncements become ever more silly, and I would like to relate his latest silliness to the post above. This is his commentary on austerity in the UK:

Britain, in particular, was supposed to be a showcase for “expansionary austerity,” the notion that instead of increasing government spending to fight recessions, you should slash spending instead — and that this would lead to faster economic growth. “Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong,” declared David Cameron, Britain’s prime minister. “You cannot put off the first in order to promote the second.”

[and later]

And we may get tipped in the wrong direction by Continental Europe, where austerity policies are having the same effect as in Britain, with many signs pointing to recession this year. 

The infuriating thing about this tragedy is that it was completely unnecessary. Half a century ago, any economist — or for that matter any undergraduate who had read Paul Samuelson’s textbook “Economics” — could have told you that austerity in the face of depression was a very bad idea. But policy makers, pundits and, I’m sorry to say, many economists decided, largely for political reasons, to forget what they used to know. And millions of workers are paying the price for their willful amnesia.

There is one very fundamental problem with his use of the exemplar of the UK for the evils of austerity; there is no 'austerity' in the UK, just talk of it. It is a point made very well in a post in the Money Illusion:

But I am seeing article after article claiming that the coming recession is due to fiscal tightening.  I was curious to see just how tight British fiscal policy actually is, so I checked the “Economic and Financial indicators” section at the back of a recent issue of The Economist. They list indicators for 44 countries, including virtually all of the important economies in the world.  Here are the three biggest budget deficits of 2011:
1.  Egypt  10% of GDP
2.  Greece:  9.5% of GDP
3.  Britain:   8.8% of GDP
Egypt was thrown into turmoil by a revolution in early 2011.  Greece is, well, we all know about Greece.  And then there’s Great Britain, third biggest deficit in the world.

There is absolutely nothing that can be described as 'austere' about the rate of borrowing in the UK. Quite the opposite - it is shockingly profligate. In reality, the UK is doing exactly what Krugman has long argued for, and has now been doing it for a long time. The UK is borrowing and spending with abandon. The really shocking thing about the UK economy is that, despite following this reckless path, it is still seeing shrinkage of the economy.

What Krugman means is that the UK government should increase the rate of debt accumulation to even higher levels. It is his solution to all ills. Just borrow more, or print more money. He cannot even see that the UK is already doing exactly what he recommends, that it has been doing so for a long time, and that it has not worked. Quite the opposite. For all the debt accumulation, the UK economy is still shrinking.

As regular readers know, I do not argue the case of expansionary austerity. I can at least agree with Krugman on this point. Real austerity will be a hard and painful path. If the UK were to balance the government budget tomorrow, the UK economy will nosedive. However, as I argue above, in the end, there is no real choice but to see the economy nosedive at some point. It is not 'if', it is 'when'. Again, as argued above, Krugman's solution will keep the illusion going for a while, assuming that bond markets play ball, but it will only prolong an illusion.

In the post above, I talked of the way that modern economists might see the two families. At the time of writing I was not familiar with Krugman. However, he is exactly the kind of economist who would propose that the Wilsons are the wealthier of the two families. He seems to really believe this......it is shocking. It is why his pronouncements are so very, very wrong.

Structural Change - The Necessary Pain

The economy of the UK is, it seems, about to undertake some significant structural change, and it is going to hurt. A lot. We still do not know the details of the forthcoming cuts, but analysts are already starting to pull out their calculators, and work out how they might impact upon jobs and businesses. The cuts were never just about reducing the number of civil servants, but about the knock on effects in the wider economy. This from the Telegraph, reporting the analysis of Begbies Traynor:

"We are concerned that the levels of business distress will increase again, potentially from the first half of 2011, once the full effects of the coalition government's fiscal tightening measures impact the economy and particularly amongst those private sector businesses most dependant on public sector contracts," said Ric Traynor, executive chairman of Begbies Traynor.

"It will not be until after the Government's Comprehensive Spending Review in October that we will know for certain the allocation of spending cuts, but there is a growing risk that, even if the UK avoids a double dip recession, it could develop a twin track economy, with public-sector dependent industries facing higher levels of financial distress than sectors which are less directly linked to government spending cuts."

Those sectors most heavily dependent on public sector spending include construction, IT, recruitment, advertising and business services.

The trouble is that this is an analysis which only goes so far. When these private sector organisations hit a brick wall, they will, in turn, hurt other private sector companies that provide goods and services for them. And then there is the withdrawal of the money from the economy as many of these workers, both directly and indirectly employed by the government, move from having employment income to unemployment income. In other words, the cuts in government expenditure will ripple out through the wider economy.

Is this a reason not to cut?

Some might argue that the knock on effects presents an argument not to cut. Better to keep on spending, as the consequences that ripple through the economy are too hard to contemplate. The problem with this view is that, somehow, somewhere, all of the activity of the people working for the government, and the businesses that service the government, must have an origin in productive output from the private sector.

This is not an easy concept to deal with, as the interaction of the public and private sector results in complex relationships. For example, a nurse working in the NHS represents a consumption of resources, but has a real output in terms of health outcomes for patients. This output is real, and might mean a worker being able to work and originate more added value within the economy. However, if we imagine that the nurse was not employed in the NHS, and instead worked in the private sector in another role, then that nurse would be creating an output that might be an origin of the added value that might pay for other nurses.

However, life is not that simple. We do not think of nurses just as adding value in the economy, but performing a role that is rooted in a sense of justice. i.e. many of us think that all people should have access to health care. As such, we do not restrict the activity of nursing to just help people who might go on to add value within the economy. In light of this, the NHS represents a net consumption of added value generated elsewhere in the economy. In order to pay for this, we must be generating sufficient added value elsewhere. Each nurse, for example, will consume goods and services from their pay, and those goods and services may originate from within the economy, or from an external economy.

When the nurse does her shopping, she may buy an avocado imported from another country, and that must be paid for from goods and services exported from the economy. Likewise, when the nurse drives to work in her car, that car may may be imported and somebody somewhere must be providing goods and services to allow for that import. If the nurse buys a domestic good, it may well be that the manufacturer of that good needs to import raw materials, and those must also be paid for from the export of goods and services. There are very few economies that even start to have the potential for autarky and, in the UK, autarky is an impossibility (if the UK is to maintain a reasonable standard of living/quality of life for the people).

Within this nurse example there is a balance at which there will be the 'right number' of nurses to ensure that there is the maximum value creation in the economy to pay for the health services. If there are too many nurses, there will not be enough creators of value to pay for the nurses...of course, it is the aggregate of all people employed in government consumption of value added in the economy that matters, and that is the question of priorities (e.g. the choice between one nurse versus one policeman).

The point that I am making here is that, overall, government is a net consumer, and is entirely reliant upon the added value that is generated within the private sector to fund this consumption. The amount that a government might sustainably consume is entirely dependent upon the amount of added value that is created in the private sector, and this is an unavoidable reality. The problem that arises in government consumption is that, in order to consume, there is an opportunity cost. If worker 'x' is employed in government activity, they are not employed in potential added value creation in the private sector. Likewise, if a company is utilised in supporting government consumption, the workers in that company are involved in that net consumption, rather than the creation of added value which might pay for that government consumption.

Somebody, somewhere, somehow, must be producing goods and services for export (and internal use) in order to support an economy, unless that economy is autarkic. That means that they must have an output which not only provides for domestic needs, but also a surplus to sell at a profit to other countries. Furthermore, the more added value that these enterprises create per unit of labour, the more goods and services that will be available for consumption within the economy, and the more available for export.

It is here that we meet the relationship between government net consumption and the wider economy. Government consumption must not reach a point at which they are consuming so much that there is insufficient surplus to pay for the imports of the country, as the country is not autarkic. If a country is autarkic, the amount consumed by the government is a splitting of resource between private and government consumption, and that is a political question. In the case of a country that needs/wants to import, it is a question of economic necessity that the country produces sufficient surplus of added value which is available to pay for the imports. The greater the consumption of the government, the less surplus is available for export.

We can see this in taxation. If a government is over-consuming relative to the private sector output, there will be higher taxation (or government borrowing). Taxation is the removal of added value in the economy into the hands of the government for government consumption of that added value, meaning that the added value is not available for export. The situation is somewhat confused by the fact that, for example, government employees are taxed, but the origins of the added value is in the private sector. In the case of government borrowing, this just means a deferral of the removal of that added value for consumption now.

What we have is a basic reality that the extent of government consumption is, in the long term, going to be constrained by the opportunity cost of employing 'x' number of people in servicing that government consumption. The principle is simple. If a person is employed as a result of net consumption of the government, they are not employed in creating the added value for the government to consume. In practical terms, this is the constraint upon government; that constraint is, in the end, determined by the absolute numbers of the workforce creating added value in the private sector, and the productivity of those workers.

If an economy is exceptionally productive, it is possible for the private sector to give an absolute greater amount of their added value to the government, and still be able to succeed in competition with others, but the total added value taken from the private sector must be determined by the relative productivity of the total number of workers within the private sector (excluding those supporting government consumption). The question for each economy is how productive the private sector is - or how much added value each worker produces. Fantastically productive workers, in relation to other countries, will allow for a larger public sector than those other workers (whether a large public sector is ever a 'good thing' is debatable, and not the subject of this post).

We can now return to those private sector workers who are (potentially) going to lose their jobs as a result of cuts in government expenditure. As they lose their jobs, some will still be in receipt of government money, in the form of unemployment benefits, but their net consumption from the economy overall will be reduced. They will be consuming less, and will therefore overall contribute to a lessening of the proportion of government consumption within the economy. They are being paid less, and all of the other expenses that surround each employee's activity disappear.

Furthermore, the skills and experience of that employee will become available to the private sector where they might contribute added value that might support government spending overall. Indeed, some employees made redundant will make this transition without any recourse to further government expenditure of overall resource. They will switch into new jobs straight away.

Buried within this scenario, of course, are the personal consequences for those that do lose their jobs. For some, this will be a major problem, and will be distressing. They will be angry at the government that has made the cuts. However, I would argue that this is a misplaced anger. The anger should be directed at a government that created an unsustainable job in the first place or, put another way, a government that sought to consume more overall than the economy could sustain. In over-consuming the resource of the country, they structured the economy in a way which was unbalanced, encouraging workers into sectors and activities that could not be sustained.

For the individuals who took work that was rooted in over consumption by the government, they had no way of knowing that their position could not be sustained over the long term. It really is not their fault that they lose their jobs, but the fault of a government that created an unsupportable structure. This is cold comfort for those workers. Likewise, the businesses that will go bust structured themselves to support the over-consumption, and it is not the fault of the proprietors that they have gone bust. They were incentivised by the government to direct their resources to unsustainable government consumption. Again, this is cold comfort when the axe falls upon their head.

The problem of austerity is that, whatever happens, the shift from government consumption of resource means that those employed in activities to support that consumption are going to be hurt, whether now or later. Someone must be hurt by a transition back to a sustainable path. That this is not their own 'fault' does not alter the absolute necessity of change. The best that can be done is to try to ameliorate the effects. We can all agree on the fact that this is unfair for the businesses and individuals involved, but to place blame on the 'cutters' is to place the blame on the wrong people. It was those that distorted the economy onto an unsustainable path that shoulder the responsibility.

I will end this post with a quote from an interview with the Chief Executive of HSBC, who seems to grasp the point:

"The reality is that is may be good to have full employment, but if that employment is driven by public employment it's telling you something very clearly... something is not functioning in your society."

In this quote, he is grasping the essential reality. Something is wrong when government consumption exceeds the ability for the economy to pay for the consumption.

Note: Over consumption in the private sphere offers similar problems, but the purpose of this post is to discuss government austerity measures.

Austerity - The Consequences

I am going to start this post with a comment from Suzy, given on my last post:

Cynicus what do you think about the theory that nothing now can save us. As is being made clear the austerity measures - that you seem to support are causing deflationary problems on a massive scale in the countries they are being used in. This means the markets are jittery about possible double dips and jittery about Greece entering a horrible recessionary scenario.

So it seems we are damned if we cut and damned if we don't. And what is worse - default or ten years of depression - which is what some commentators think Greece now faces.

The problem identified by Suzy is indeed a real problem - damned if we do, and damned if we do not. It will not have escaped the notice of readers that the word 'austerity' appears to be the word of the moment. This is a report from Forbes which is headlined as 'Austerity - the New Worrisome Buzzword':

Dictionaries define austerity as economic restriction, scarcity, sternness, hardship.

No wonder then that people in Greece and Spain are taking to the streets in protest of the austerity measures required of countries accepting aid from the EU/IMF rescue plan announced a week ago. Among the austerity measures are pay cuts, cuts in pensions, later retirement ages, and fewer government services.

The push for austerity adds to concerns that the rescue from record government debt loads may be as negative for the economies of Greece, Portugal, Spain, and Ireland, and therefore the fragile overall European economy, as actual defaults on the debts might have been.

In the U.S., worries over the austerity programs in Europe have overwhelmed the positive U.S. economic reports that have been coming out. Among the worries is that bank and investor losses on government debts in Europe could undermine confidence in global financial systems again.

The report goes on to say that the State of California is also implementing 'austerity' measures, and it is also apparent that 'austerity' measures are also in prospect in the UK. Ireland has already implemented such measures, and Italy appears to be in process of measures. What we are seeing is a grand beauty contest, in which sovereign states are in competition, one with another, as to who will be in receipt of further credit. The exception, of course, is the US, which is still relying on the irrational belief that it is a 'safe haven'. Regular readers will know that I have always expected a reaction to crisis would be to initially flee to the illusory safety of the US, and this is what has taken place.

What we are seeing is that we are now in a situation in which 'austerity' measures are taking place simultaneously, and that demand for goods and services will (in aggregate) start to fall as the austerity measures bite. This has led to a lot of talk about Fisher's debt deflation theory, and fears of deflation are commonplace in many reports. The following is a sample of the kind of discussion that is very common:

Germany is pressing other eurozone countries to push ahead with brutal austerity measures to slash their budget deficits. Spain, Portugal and Greece have already announced their austerity measures, while Italy is expected to soon announce tough budget cuts. Meanwhile, to comply with its new balanced budget laws, Berlin will have to slash its budget deficit by about $US13 billion each year for the next five years.

There are worries that this strong contraction in government spending in the eurozone will force many economies into recession, making it even more difficult for countries to collect the tax revenues they need to stabilise their debt levels. Steep declines in economic activity will put additional downward pressure on prices and already there are signs that prices are falling in Portugal, Spain and Ireland while underlying inflation in Germany is close to its lowest levels in more than a decade – making it even more difficult for countries to service their debts.

I suggest that you re-read the second paragraph. The argument is this:

1. If a government reduces the quantity of borrowing, the economy will contract.
2. If the economy contracts, there will be less tax revenue.
3. If there is less tax revenue, debt servicing will be more difficult.
4. Stabilising debt levels needs borrowing to be continued.
   

All I can say to this extraordinary thinking is ??????! Are they serious? In order to stabilise borrowing, there is a need for more borrowing, to increase activity, such that some of that borrowing ends up back in the hands of the government as tax revenue so that they can service the borrowing that they are undertaking. Apparently, this will stabilise debt levels.

Within the article quoted above is exactly the dilemma proposed by Suzy. Damned if they do, and damned if they do not. Governments have the option of continuing the high borrowing until, finally, investors take fright, or they cut back borrowing to sustainable levels, and see the GDP go down as a result of reduced borrowing - and then see the tax revenues fall, causing further tightening, and all the while seeing their debt to GDP ratio move in the wrong direction, thereby further alarming investors.

Within this scenario is a problem, which I now feel I am endlessly repeating. This is that countries have mistaken growth in GDP for real growth, when the reality that the growth was not in their ability to generate wealth internally for consumption, but a growth in their consumption of the output of other countries. When you borrow $1 billion a year from China, you can purchase Chinese goods to that value. However, as with all borrowing, China would expect to get the $1 billion back, and with interest, which means an equivalent amount of output from your own economy. If we think of it in simplistic terms, we are borrowing 50 million colour televisions from China, and must repay in (or the equivalent of) 55 million televisions. When we make our repayment to China, unless we have an economic miracle, we will have less of our output for ourselves. A proportion will be returned to China.

What we have in effect is a situation where we appeared to be 50 million colour televisions richer, and now we no longer have these, and in addition, we are having to return some of our own output of colour televisions to China (I know, we do not make them anymore). We immediately feel a loss as we commence living on our own output, and that output available for consumption is further reduced due to having to apportion some of it to repay our creditors. The 50 million televisions were never our output, though we believed this to be the case. Because we never realised this was not our own output, we are now in a situation where there is resentment at the prospect of falling living standards, and reaction against living within our means, and paying our debts.

What we now have is a situation in which we are having to face some tough decisions. For the countries that have the ability to devalue, they can do so. However, if they want to continue to have access to credit, they must devalue at the cost of paying much higher interest on their debt. In particular, where government borrowing is in the economy's own country, the repayment is made in devalued money (think of returning three quarters of a television in return for the one that was given as a credit) and, unsurprisingly, creditors will protect themselves against the risk of you doing this again. In addition, this lowers the standard of living of everyone in the country which has the currency devalued. I always give the example of the person who enjoys imported Belgian beer having to pay more for their beer to illustrate this. This simple pleasure takes a greater proportion of your wages, and you are therefore literally poorer.

The above scenario is, of course, inflationary, and we are seeing climbing inflation in the UK, which has seen a steady devaluation of the £GB. The inflationary effects are taking place despite the contraction of the economy. A long, long time ago, I asked myself the question of whether we could expect inflation or deflation. I pointed to a falling £GB outstripping the impact of the contraction of the economy, and this is what has taken place. In a letter to the Chancellor, explaining inflation being above target, the Bank of England has recognised this impact (belatedly).

Interestingly, the Bank of England is still talking of 'spare capacity' in the economy - what they are not talking about is whether that capacity might have any utility. In a crude example, if we think of a shop worker who has been made redundant, how might the worker be spare capacity. If retail was structurally over-represented in the economy, and the economy has corrected the credit fuelled over-capacity, what is this worker 'spare capacity' for? Can they go and work in an engineering works? The same might be said of a wholesaler to the catering trade, which has seen business grow at a rate fuelled by excess credit expansion. They might have 'spare capacity', but it is pointed at the wrong sector.

At present, the only way that this 'spare capacity' might be utilised is if a government keeps pouring borrowed money into the economy to soak up this spare capacity. However, the reality is that the capacity must eventually disappear. At some point, the credit will stop, and we are seeing this taking place. For many countries, they are under threat of a complete halt to further credit. The only solutions to the problems is to re-balance their consumption and output, and that means to move from living on credit to generating surplus to repay the credit. The problem is that this can not be achieved overnight, and without considerable economic destruction. The expansion of sectors that were reliant upon credit will have to shrink to a size which is appropriate to the economy.

The solutions to these problems are varied. In the countries locked into the Euro area, in the end, it must mean wage cuts which will allow them to export. In countries that have currency independence, they can 'inflate their way out of trouble' through devaluation, thereby commencing a process of increasing inflation internally, and thereby indirectly lowering wages to allow their economies to become competitive. In doing so, they will pay a high price for any further borrowing. You may note, that this still means reduction in wages, and simply means that the wage cut is not in quantity of money but undertaken through lowering the value of money.

However, there are signs that inflating out of trouble may not be the chosen solution. It seems that austerity is the more probable route, and that will mean wage cuts. It may be remembered that making a saving of £50,000 a year with one redundancy is the same as cutting the wages of many workers by £1000 each. In both cases, the wage cut is real, only in the former case it is concentrated in one person (the provision of unemployment benefits is, of course, a complication, but we will leave that alone for the sake of simplicity). There are some problems in implementing across the board wage cuts, such as minimum wage laws and the provision of benefits. I will explain.

In the case of a minimum wage, the floor of a minimum wage worker will also influence the wages of higher paid workers, such as their supervisors, or the manager who manages the supervisor. In each case, there is a necessity of a differential and a floor on the overall wages is therefore set by the minimum wage. Benefits also create a minimum wage as follows (from my first post, A Funny View of Wealth):

As mentioned before, all things in the UK are not equal due to the minimum wage, but also because the UK employer needs to compete for labour with the UK benefits system (which is an indirect minimum wage that applies to anyone entitled to social welfare benefits). This system allows an individual to remain economically inactive, or to choose an option of accepting a low paid job for very little real remuneration despite a major increase in the expenditure of their labour. In such cases the value of the labour expended is far below the minimum wage as it needs to be calculated as the weekly pay minus the benefits, to give an actual wage for the work done. The rational person in this situation might reasonably ask whether the loss of their free time to work is worthwhile for what will often be little financial incentive as, in this situation, the UK worker is often working for extremely low wages[10].

The problem with these minimum wage effects is that they have potential to displace lower wages into high unemployment. It encourages a system of haves and have nots. The upside is that it encourages organisations to do more with less labour, thereby encouraging improvements in productivity, but does so at the cost of throwing individuals to the scrap heap of unemployment. Whatever happens, however it takes place, wage cuts are on their way - whether concentrated into unemployment or shared more equitably over the workforce.

The real problem in these scenarios is that everyone seems to be looking to exports as the route out of the global economic crisis, whether China, Spain, the UK or the US. Just looking at the US and China, China has enjoyed an export boom partly based upon credit provision to the US, and its industry is directed in part to servicing those US customers. In other words, China has used massive provision of credit to support an export sector that does not have enough customers. As such, it must also eventually adjust. As 'austerity' takes over, their export sector will suffer. As such, China will do everything it can to support the export sector, rather than risk unemployment at home. They need to keep exporting. At the same time, the US are seeking ways to compete in export, and are now facing a China that seeks to continue to win in the export game. A similar scenario can be painted for the PIIGS and Germany.

In the examples above, I am simplifying, but the essence of the problem is as I have put it here. Competition on labour costs is on its way, with the aim of winning the export game. However, not everyone is going to win in an export game when many of the markets that previously drove exports are going into decline. Whilst continued borrowing by debtor countries might prop the system up for a little while longer, it does not alter the fundamental imbalances that the credit boom created. All over the world, there are industries pointing at markets that simply can not afford to consume the goods they have been consuming in recent years. They do not have the capacity to both repay and consume at the same rate as they were when the credit taps were wide open. As these markets contract further, as austerity bites, each country will seek to generate competitive advantage. In the case of the major debtors, they will have to, one way of another, cut their wage bills.

But what happens if more and more countries are doing the same thing - whether directly or indirectly through devaluation? How does it end?

The answer to this question lies in the eventual re-balancing of the world economy, and in particular a re-balancing in the allocation of resources available for consumption. I have given an explanation of why this is a problem in earlier posts, and it is too long to detail here. In short however, the amount of commodities in the world has yet to catch up with the new input of labour represented by the emerging markets. If the labour force increases without a commensurate increase in resources, then there must be a period of hyper-competition. This hyper-competition was emerging but was masked by the credit boom. However, if you want to understand this, I suggest you read one of the posts on the subject, such as this one on Huliq.

Having said that there should be a re-balancing towards the emerging markets, this is to ignore one thing. The losers in this process do not want to see this happen. This is where politics, and in particular geopolitics come into play. How the game might play out is, in many respects, dependent upon how world leaders address the problem. How they might react as the economic crisis continues to unfold, and fully reveals itself, is going to be highly unpredictable.

Note 1:

Within this mess, we have the further complication that the US is seen as a law unto itself. Whilst they have similar structural problems to many countries faced with crisis, their problems are still being hidden under the irrational rush to safety to US assets. They are still on the path of borrowing to support their economy, and to generate the tax revenue to support their repayments, and to gradually lead their economy to the point at which investors finally take fright. Where California is leading, the rest of the US will eventually follow.

Note 2: Some replies to comments on the last post

Ginger Tosser: Yes, the US is currently a safe haven, but they have the same problems as elsewhere......it is only a matter of time.

Kiwi: I long ago proposed Norway as the best bet.....stable government, resource rich, large sovereign wealth fund....but even then we can never be sure in the chaos that we are now seeing.

Ian: I have a few moments where I have metaphorically held my breath, asking is this the big plunge?

Anonymous on the Scorched Earth: There has been considerable commentary on the state of what was inherited by the new UK government. It is a good opportunity to get the skeletons out of the cupboard and address the real scale of the problems in the UK. I have not yet commented on the election result, as I am waiting for more firm policy details.

A Real Black Person (yes, that is the commentator's posting name): I liked your pithy comment on Dubai, as follows:

But still, it makes one wonder what compelled them to start building very lavish and exquisite real estate properties for rich people that don't exist?

An extreme example of pointing in the wrong direction, unless they manage to market these to the new wealthy....

General: I have worked up the list of comments, and that unfortunately is all I have time for. However, some interesting links and comments as ever....I am always impressed with the quality of the comments.

Note 3: There is an error in the Huliq article, if I recall correctly. A section should read 'zero sum game', not 'zero sum gain'.