Sovereign Default - Who is at Fault?

I am watching the Greek crisis as it takes its painful course, and have noted that there are some views which seem to suggest that Germany has an obligation to rush to the rescue. A Guardian article is typical, though the extract below does not really capture the overall sentiment of the article:

After days and days of hesitation and apparent indecision, when speaking to the audience at the rally in Bocholt, Merkel played the populist card. We're right to tell the Greeks: you have to save money, you have to be candid and you have to work on your honesty, otherwise we can't help you, Merkel said.

It's one thing to ask Greece for strict austerity measures in return for a bailout deal. But when Merkel implicitly said that the Greeks weren't honest and had poured money down the drain, she didn't ask for anything. She didn't even try to calm the fear among Germans that contributing billions to the Greek bailout will lead to further wage cuts and tax freezes.

Perhaps, the sentiment is best expressed with the picture of Angela Merkel that accompanied the article. The picture is quite disgraceful:

What we are seeing is a pass the parcel of blame, and Germany looks like will be left holding the package. However, all of this is to lose sight of the reality of the situation. The Greek debt is the fault of Greece, and nobody else.

There have been suggestions that somehow Greece was enticed into debt, that it really is not their fault. It is the view that Greece is like a consumer persuaded into a dodgy Hire Purchase agreement, without realising the consequences of signing on the dotted line. However, in this case, our consumer has lied about their level of debt on the application form. We might have less sympathy for this consumer...

However, it is not like a consumer signing a deal, as there is a critical difference. Whilst a consumer might plead ignorance, lack of understanding of the consequences of their own actions, not understanding the real cost of the loan and so forth, this is not the case with a government. In the case of governments, they employ experts whose sole job is to examine the economic consequences of the policies of government. There is no excuse of ignorance. Every time that a government metaphorically signs on that dotted line, they do so with expert advice.

What of the Greek people? Greece is a democracy, and therefore the Greek people themselves might be seen as culpable. They elected the governments that racked up the debts, and they might be seen to take a collective responsibility, as part of the contract implicit in democracy. However, I am reluctant to blame the Greek people in some respects. I do not know the role of the press in this debacle, and whether there was a sufficient momentum of criticism of the debt accumulation to give the Greek people an informed view of the eventual consequences. At the very least, the lies of the government not only hid the extent of the problem from the creditors but also from the electorate.

On the other hand, the response to the crisis is not encouraging. The strikes that are being undertaken to prevent the austerity measures are a wilful denial of the reality of the situation. Greece is broke, does not have the means to pay the bills, and are asking for credit. If they continue with their current spending, they will not pay back the money, and it is reasonable to ask that they tighten their belts, and start living within their means. It is not wickedness of Germany to ask for this, but reasonable. There is absolutely no moral obligation for Germany to bail out Greece. The government of Greece made their choices, and are responsible for the consequences.

In addition to the implication that Germany should, in all cases, bail out Greece, economic arguments have been put forwards, as in this fairly typical example:

But there are other aspects of the crisis which are common to many – most advanced economies have had their finances stretched to breaking point by the recession – and unless some kind of line is soon drawn in the sand, Greece's problems will spread to the next weakest link in the chain, widely thought of as Portugal, and then perhaps to others too.

What's more, German and French banks are big holders of Greek and Portugese debt. Default itself might trigger a second round of banking collapses, with further deflationary consequences for affected nations.

This is a variant of what I will call the chain reaction argument. This is the idea that a line in the sand must be drawn in Greece to prevent further banking crises or further sovereign debt crises. The problem is that, as has been found with Greece, even if the debtor countries massively reduce expenditure, the bailouts will be of massive proportions. The level of bailout money for Greece just keeps on climbing, and the same will apply to the next 'at risk' countries. If the creditor countries open their cheque books, where will it end?

If they start, at what point will they call a halt? At Portugal, at Spain? More to the point, the countries supplying credit are already running their own deficits. They must borrow yet more money to bail out the debtor nations, thereby creating greater risk of having their own debt crises, and borrowing money to lend to countries that appear to be reluctant to face up to the consequences of their previous profligacy; in other words borrowing money to lend to poor credit risks that insist on continuation of spendthrift ways.

I normally try to take a more objective view of the economic crisis, but there just seems to be so much complexity being overlaid over a simple situation that I am becoming more frustrated. I have just submitted a new article to TFR magazine (it should be published in the print and online version soon) and it points out that we are not looking at 'contagion' to other countries, like a disease is contagious, but rather that the doctors are learning how to diagnose the disease - and the disease is fiscal profligacy. There are a host of countries that have the same problems, including the UK and US. It is time for these countries to act, as there simply aren't going to be any saviours that will ride to the rescue. Even a small country like Greece, with a relatively tiny economy and relatively small absolute debt levels is having trouble raising a rescue package.

Above all, this is not a contagious disease, but is the fault of the profligate countries for living beyond their means. In Greece it is (at least) primarily the fault of the government, and the same can be said of the other countries that are at risk. There are no excuses - they had the resource of 'experts' to draw on, the resource to examine the risks, and the resources to make decisions. There is no risk of contagion, as there is no disease. It is, plain and simple, a self-inflicted problem, and the solution to the problem lies in the hands of the policy makers.

The solution also (to a lesser extent) now lies in the hands of the electorates of each country. The reality of the consequences of profligate debt accumulation are now evident, and even the mainstream media are facing the reality of the tough choices. The electorates no longer have an excuse - the reality of the dire situation is now being placed in front of them. In the case of the UK, it is time they demanded of their politicians real honesty over what they plan to do. If not, they are by default culpable. The UK is lucky in this respect, having an election at the very moment that the light of reality is shining on the consequences of fiscal irresponsibility. They have a moment, brief as it is, to demand a change, and demand reform.

For other countries, there may not be such an opportunity before it is too late. In these countries, it is up to the third estate - the press - to wake up and pressure for reform. They need to shift attitudes, to create a groundswell of opinion that rejects the buy now pay later profligacy, and takes the lesser pain of reform now. It is time to pressure governments to tell the truth, and accept that they can not borrow and spend forever. It is time to accept that there are going to be no saviours, that the resource for the scale of bailouts needed will never be there. It is time to wake up from this complacent slide into ruination.

Notes:

I have watched with sadness as the UK election descends into the farce about the Prime Minister's calling a person a bigot. Whilst this is unpleasant, it seems to just be another distraction from real debate - the question of what is to be done about the economy. Whilst Gordon Brown's character is a legitimate subject for debate, the greater debate is buried.

I am, as you may guess, frustrated. I am still not sure whether the EU will hold off the crisis for a little longer, but in all cases, the ground of the crisis is now clearly in sight. Maybe there will be a last ditch rescue, and the crisis will take another pause....but maybe this is the start of the final phase. Your thoughts, guesses are welcomed in the comments section. My gut reaction is the start of the last phase, but I have called it wrong before.

As a final note, I have taken a different approach in this post, and hope that it is coherent. Let me know what you think.

The Greek Crisis (again)...

Yet again, I have an unfinished post, and again it is due to events that I have changed direction. The Greek crisis has now entered a new phase, with the bailout from the IMF and EU finally enacted:

Greece bowed to market pressure yesterday and formally requested a bailout from the European Union and the International Monetary Fund.

It is the first time a eurozone member has asked for a financial rescue and it is likely to test European political cohesion as well as the stability of the euro itself.

Greece asked for the €45 billion package after being downgraded by the Moody’s credit rating agency on Thursday.

The first problem is that it is just not going to be enough. The problem of the scale of Greek debt is worse than was feared:

Greece' deficit for last year is worse than the cash-strapped country originally reported and could still be revised higher, the European Union said Thursday, news that weighed on the common currency. A sharp upward revision to the 2009 figure, which sent Greek bonds into a tailspin, was surprising because Greek officials just two weeks ago denied reports of a big spike.

And the bailout will only take Greece so far.....

However, there are concerns that despite the unprecedented scale of the loan, it will not be sufficient to do little more than buy the country time, allowing it to finance its state only for another few months. The full details of the loan will not be laid out in the next few weeks, as IMF and euro area officials hammer out an economic plan for the country, which is likely to involve further severe cuts in public spending.

Then there is the problem of the potential challenge in Germany as to whether the Greek bailout is unconstitutional:

The German constitutional lawyer seeking to derail Berlin's contribution to a Greek rescue plan said he likes his chance better this time than in 1998, when he tried unsuccessfully to block Germany's adoption of the euro.

Karl Albrecht Schachtschneider, a retired University of Nuremberg law professor and expert on the constitutional court, said he believes that the Greek aid package is in clear violation of European treaties and the German constitution and sees a chance of convincing the court this time.

What may seem a contrarian quest has attracted attention in financial markets, where investors fret over any sign that Germany would withhold or even delay providing its share to the EUR30 billion rescue plan if Greece requests it.

Schachtschneider is drafting the legal complaint with three other established euro skeptics, all of whom are into retirement age.

Working with him are economics professors Wilhelm Hankel, Wilhelm Noelling and Joachim Starbatty. Noelling is a one-time governor of the Bundesbank, Germany's central bank. The same foursome were behind the ill-fated legal challenge 12 years ago.

I would like to give some perspective on whether the challenge might be realistic, but must confess that I have no particular insight on the issue. Some time ago, when first reading about this (sorry, no references), I did see some fairly persuasive cases for the challenge, but still remain on the fence with regards to whether the challenge might gain traction.

As I have posted before, the real issue of interest is the wider consequences of the Greek crisis. When first starting this blog, I contemplated the possibility that the Euro might not survive the crisis, and others are now seriously contemplating this possibility. This is Edmund Conway of the Telegraph writing from the G20:

Though they don’t admit it, they also privately suspect that this crisis will be the biggest challenge yet for the euro project. And for many it is no longer anathema to suggest that the euro may not survive this crisis – at least not in its current form.

I would agree that, at the very least, that there will be strong pressure to reform the structure, with Germany leading the way. Of course, the only kind of reform that might work is closer regulation of Euro-wide fiscal policy, which implies a significant loss of sovereignty of Euro member countries. Somehow, I suspect that, even for those who support the European project, this might just be too much.

Then there are the next contenders for debt crisis. Spain and Portugal are looking increasingly vulnerable:

Iberian stocks fell sharply Thursday amid concern the escalating Greek debt crisis could spread to other southern European countries with troubled finances.

Madrid's IBEX-35 index ended 2.19% lower at 10,821.9 points, while Portugal's PSI-20 index closed 2.57% down at 7,751.95 points.

"There's confusion and a great insecurity in the market," said Karsten Sommer, a trader at BCP in Lisbon, adding that rising government sovereign yields are bad news for stocks.

As Moody's Investor Service Inc. downgraded Greek sovereign debt, the cost of taking out insurance of Greek government bonds through credit default swaps surged about 10% to 620 basis points earlier Thursday. Spanish CDS spreads were also pushed higher to 171.5 basis points from 158.5 earlier in the day, while Portuguese CDS spreads moved to 260 basis points from 232.

Banking stocks were hit hard, with Banco Santander SA (STD) down 3.1% to EUR9.91, and Banco Bilbao Vizcaya Argentaria SA (BBVA) plunging 3.1% to EUR10.55. Portugal's Banco Espirito Santo SA (BES.LB) shed 4.1% to EUR3.569 after a Nomura downgrade.

....then there are the banks that hold Greek bonds, with the largest holders in France and Germany. A Greek default will put new stresses on an already stressed banking system. Unlike commercial loans going sour, it will be hard for the banks suffering such losses to have the news buried or obscured:

Private investors are already seeking ways to decrease their exposure to Greek debt although European banks appear to own some 58% of Greece’s 270 bln euro debt. Greece’s indebtedness to European banks appears to have been one of the key facts that convinced Brussels to take the lead and seek a mainly European solution.

It is worth reminding readers that the Basel rules gave OECD debt a zero risk rating in the calculation of capital adequacy ratios..... These are the same regulators who will now, apparently, be able to foresee future risk and prevent it. The new regulation will, of course, learn the lessons of the past, implement a new and more secure structure, and so forth. Just as they do after each crisis and problem.....and remember, this is not new obscure financial instruments, this is sovereign debt. This has been around for centuries.

With regards to the next phase of the crisis, it is tempting to use emotive expressions such as 'now that the markets have tasted blood...' and all of the cliches that we see in so many articles. However, it is not a question of 'tasting blood', but rather the facing up to the reality of the terrible fiscal position of so many 'rich world' nations. The markets, the holders of 'safe' sovereign debt, are just waking up to the fact that it is not, after all, safe.

The big questions, aside from the crisis in Greece is who is next, and where the bailout money might come from? Will the EU also be prepared to bailout the next country in line, or the next....? How about the IMF? Can it fund a series of EU country bailouts? As has been discussed in the case of Greece, this bailout is likely to just be the first tranche....Greece will need further finance later. Then there will be the steep fall in Greek GDP as the austerity bites, and the picture will be one of a GDP to debt ratio moving in the wrong direction....it will not be pretty. This will cause even more alarm, as the markets see what happens to an economy that is mired in debt and where GDP has been sustained/obscured with debt.

And then...if the crisis gathers pace, will the markets start to look at economies such as the US, the UK and Japan. For example, Japan has now had a rating downgrade:

Fitch Ratings said Thursday that Japan's credit ratings face downward pressure in the medium term due to the ballooning debt, increasing the urgency that the government come up with a plan to get it public finances under control.

"In the absence of sustained economic recovery and fiscal consolidation, government debt will continue to rise, placing downward pressure on sovereign credit and ratings over the medium term," the credit-rating agency said in a report.

"The Japanese government is one of the most indebted in the world," Fitch said in the report titled, "Just How Indebted Is The Japanese Government?"

Fitch estimates Japan's headline gross government debt reached 201% of gross domestic product at the end of the last year, the highest ratio of any country the agency rates.

Any downgrade would elevate market concerns about Japan's creditworthiness and could prompt investors to unload their government bond holdings.

"It's important to show that the government is managing fiscal policy in an appropriate manner," Cabinet Office Senior Vice Minister Motohisa Furukawa said at a press conference following the release of the report.

Just for the sake of interest, I undertook a Google new search for 'sovereign debt' and found an article that is illustrative of the growing concerns in the media:

So here’s a brief look at some aspects of the UK’s debt vulnerability compared with that of France, using a useful table in an IMF report issued this week. (The link is below).

It shows the rating agencies agree with the continental finger-pointers. France’s top triple-A rating is stable; while the UK’s has a negative outlook. That’s even though the UK’s deficit at the end of this year will be below France’s, at 78% of GDP compared with 84%.

By some measures, France is more vulnerable. Foreigners tend to be more skittish than domestic bond holders and foreigners hold only 22% of British debt, compared with 58% of France’s. On top of that, a fifth of France’s debt is maturing in the next year, compared with 8.4% of UK government debt.

The article is not of particular interest of itself, but for the way that it is framed. The article is about relative vulnerability. The framing of the article speaks volumes. The IMF now sees sovereign debt crisis as a real possibility, and they are a long way from the (sometimes) radical musings of a blogger - they are the embodiment of the mainstream:

Greece's upheaval could mark the starting point of a "new phase" in the global crisis if countries don't get their fiscal houses in order, despite the low risk of contagion, the International Monetary Fund said Tuesday.

While the IMF slashed its projections for bank losses from the crisis to an amount deemed manageable, the rapid buildup of sovereign debt among advanced countries to levels not seen since the end of World War II has emerged as the biggest threat to global financial stability.

"In spite of recent improvements in the outlook and the health of the global financial system, stability is not yet assured," said Jose Vinals, director of the IMF's monetary and capital markets department, at a press conference to discuss the semi-annual Global Financial Stability Report.

"If the legacy of the present crisis and emerging sovereign risks are not addressed, we run the real risk of undermining the recovery and extending the financial crisis to a new phase," he said.

All of this leads to a question. When, and under what circumstances are the policymakers, the politicians and economists cheerleading for fiscal profligacy going to wake up to what is taking place. When I first started writing this blog, the situation was different. Reality was obscured, theory was not being tested in the real world, and there was some kind of excuse (albeit a poor excuse) for the lunatic policy that was being enacted. As we now see the consequences, there is simply no excuse for the continuation of the madness, but still it continues.

Notes:

The UK election has taken some unusual twists and turns of late, with the Liberal Democrats making a big splash. However, I am not convinced that they, any more than the Conservatives or Labour, are serious about the dire fiscal crisis. Interestingly, some commentators and analysts seem to think a hung parliament is not a problem. I am agnostic on this, as it is always possible that the right leader, and the right coalition might work, but do recognise that this represents big uncertainty. What will finally matter is not who does it, but what they do.

Yet again, some very interesting comments on the last post, and it good to see some further challenges to Lord Keynes. Interestingly, his view of economics is now starting to face the real test. I would like him to be right, as I do not want what is coming, but alas I think this unlikely.

My original post was on housing / real estate, and I will try to finish in the week.

World Economy - What Happens Next?

As I mentioned in my last post, I thought it might be worthwhile to take a pause from the news and try to pull together what all of this means. By coincidence I finally had time to read my copy of the Economist from last week, which included their review of the situation. It was surprising to see how far they had moved towards the interpretation of events discussed in this blog. However, in several critical respects they differ.

For example, the Economist is broadly supportive of the bank bailouts and coordinated action of governments to try to fix the crisis. Across many posts I have listed many reasons to be against the bailout, so I will try to summarise the reasons for why this is an error. In one post I illustrated why this was a bad decision with an analogy of a family. The family have been spending more than their income for many years, and were already in severe financial difficulties. They are increasingly reliant on borrowing to sustain their lifestyle, are using borrowing to pay back previous borrowing, and are slowly but surely heading to bankruptcy. Meanwhile, the husband is having his working hours reduced, and the mother is facing the possibility of redundancy. In other words, their income is about to drop. In such circumstances, who in their right mind would suggest the solution is to borrow yet more money? The answer is obvious - nobody would give this advice. Instead, the advice would be to accept the reality of the situation, and tell them that they urgently need to change their lifestyle such that they can live within the means of their income. Ideally, they would also need to change enough to start paying back their debts.

For some reason, when it is a country in this situation, the solution to the problem is to borrow more money, the method of financing the bank bailout. This is the simple reality. Nobody disagrees (now) that the Western economies, in particular the UK and US, have been borrowing more money than was sustainable, but for some reason it is acceptable to get out of the situation through increased borrowing. Rather than accepting the reality that we must live withing the means of our (diminishing) income, the solution is to just borrow more money.

In a more recent post, I asked what the borrowing would be used for. We know that the money is being pumped into the banking system, but to what end? Were it to be used to invest in wealth creating assets, then I would have no argument with the Western governments extending their borrowing (whilst they still have the means to do so). However, the news suggests that the purpose of the bailouts is just to pump new sources of credit into the wider economy. In other words, it is just being pumped in to restore the supply of money to maintain the 'service based economy'. Will this money see the development of manufacturing companies, or be used for investment in new plant or technology, or be invested to develop services for export? There is no indication that this will be the way that the money is used. It is just an increase in overall debt, and is digging a deeper hole for the economy to sink into.

Governments are claiming that they will eventually recoup the money that they are lending, but the reality is that they will be encouraging the banks to lend the capital that they are injecting into the system. In so doing, they will be encouraging lending into a failing economy, which means lending against devaluing assets, lending to consumers who are increasingly likely to made unemployed, and businesses with ever greater risk of bankruptcy. In other words, the money will be used for lending into high risk, and will therefore see yet more mis-allocation of capital. In encouraging lending for the wider economic good, the governments are likely to just encourage yet more bad debt to be developed.

We then come to the question of how the money will be repaid. In my early posts on the bailouts, I emphasised the fact that this is spreading the damage done to the financial system into the wider economy through the necessary (eventual) increases in taxation. This means that the genuinely productive parts of the economy will be saddled with greater taxation, and will reduce their ability to compete. In other words much of the money being borrowed will be poured into the non-productive parts of the economy, and the cost of the borrowing will hurt those parts that have genuine wealth creating capacity. It is a recipe for long term economic damage.

So what is the bailout actually for? There is endless talk about restoration of 'confidence'. This is a very curious idea. What is the point of confidence? Does it produce wealth, does it change the underlying economic circumstances? The reason that there is no confidence is for the very reason that the underlying economic circumstances are so poor . As such, the $2 trillion being used to prop up the banks in the Western world is being used to create a false sense of confidence. This is a frighteningly irresponsible way to utilise this money, as the restoration of confidence can never be anything more than temporary, because the underlying economic reality is so poor. As it is, these massive borrowings being poured into the financial system are not even achieving this foolish aim in the short term. The rate of interest for inter-bank lending is barely moving, stock markets are still teetering on the edge of collapse, and so forth. At this stage, it is impossible to say that there will still not be an upturn in confidence, but such an upturn is unlikely, and in any case will eventually be destroyed by ever more bad economic news. (Note: I discuss why the value of money is built on confidence here, which would suggest that confidence is important. This may seem self contradictory, but the reason it is not is that confidence must have a foundation in economic reality)

So where does this leave the economies of the Western world? At the moment, the rest of the world is still lending into the Western economies. I forget which was the post in which I made this analogy, but this is a situation like the creditors to an 18th century aristocrat. His family has always been wealthy and his creditors continue to lend money in the belief that he will always be wealthy. However, the reality is that he has no prospect of ever paying back the borrowing. All it takes is for one creditor to ask for repayment, and the result will be a loss of confidence in the aristocrat's ability to pay. At that point, when the credit stops, bankruptcy will quickly follow. His income does not cover his expenditure, and without the continuation of lending, he is seen for what he is - a bankrupt who has been living on the success of his forbears.

The collapse of the economy of Iceland will probably be raising questions about the creditworthiness of other Western economies. The UK government in particular is making it very clear that the intention is to increase borrowing, and is therefore declaring that it intends to borrow its way out of trouble. Rather than trying to cut back on spending, it fully intends to pretend that there is no underlying economic problem, with no need for reform. It is business as usual, all the while with income dropping, and borrowing increasing. No explanation is being given for how this increase in borrowing is to be repaid, what source of new wealth is around the corner to allow the repayment of this ever-growing debt. The question this raises is how it is that the rest of the world will continue to lend? At what point will they ask the question of how this debt will ever be repaid?

The fundamental problem is this. As long as the rest of the world keeps lending, there is demand for the Western currencies. As long as this demand continues, it helps to prop up the value of the currencies. This in turn protects the value of the money that is being lent. What happens if the amount of lending decreases is that the demand for the currency will drop, and with it the value of the currencies. The trade balances of the US and UK in particular have been negative for a long time. Put another way, the demand for the $US and £GB is driven by lending, not by demand to buy goods and services. For those that are creditor countries, they face uncomfortable choices. If they cease lending, then the currencies of the West will collapse. If the currencies of the West collapse, they will lose huge amounts of money on the lending they have already made. On the other hand, if they keep lending, they are faced with the problem of how the money will ever be repaid. In crude terms, do they continue to throw good money after bad?

It is for this reason that I have predicted that it will not be long before the lending stops, and that this will lead to government defaults. I can only guess the time scale because, at the end of the day, it requires that the creditors of the West ask the right question - the question of how their money will ever be returned to them. It will also require them to accept the losses on their previous investments, which will be a hard pill to swallow. Finally, they will know that, with the collapse of the Western economies, they will be pulled down with along with the West. For countries like China, with very real prospects of social unrest, they will be balancing the cost of continued lending against the survival of the Chinese Communist Party. Do they continue to finance the Western world's ability to live in comfort, do they continue to lend their hard earned money to prop up a decadent and bloated Western world - for that is how they will see it. They produce, and the West consumes and does not ever pay the bill for the consumption. It is hardly a good deal for them.

So what happens if countries like China decide that enough is enough. It is at this point that the Western governments find that they can no longer pay the bills. At this point they must either print money, or dismantle huge parts of the state. The $US, the Euro and £GB will fall through the floor. The peg to the £US used by the oil states will be dropped, and the cost of oil will soar. Even without printing money, the rate of inflation in the Western economies will soar, and the result will be complete economic chaos. The reality will be that oil will be oversupplied, but the shift in the currencies of the Western world will mean that, for the West it will become relatively very expensive. The same will happen with other commodities. This is the rebalancing of the allocation of commodities that I discussed in previous posts. I spoke of the competition for finite resources between the emerging economies and the Western economies, and that the West would lose out, and find its share of world resources decline. This will be the mechanism by which this decline will be transmitted.

I have not spoken very much about the social and political consequences of what will happen, as this blog is focused on economics. However, at this stage, it is worthwhile discussing this briefly, as there will be a feedback into the economic situation. If I am right that the lending into the West must end, and the result of this end to lending is as I have predicted, then we will all be in for a roller-coaster ride. The shock to the Western world will be dramatic and painful. In these circumstances, it is an ideal environment for demagoguery. It is the moment of the populists and the rabble rousers. There is a real chance of massive social upheavals, and even challenges to democracy and capitalism. In the rest of the world, there will be similar upheavals. The biggest worry is China, which already has a state that already looks like a worrying hybrid of pre-WWII Japan and Germany. There are many flashpoints for conflict, such as Taiwan. With a government with legitimacy built upon economic growth and nationalism, what happens when the economic growth stops? The Economist magazine is optimistic about the prospects for China in this upheaval, and we can only hope that they are right. I have always been very slightly optimistic that China will pull through this period with only moderate damage, but still have many serious reservations.

I mention the political and social dimension for the reason that the result of the next stage of the crisis will lead to a situation of chaos, by which I mean chaos theory (no doubt serious chaos theorists will shoot me down on this usage, but I hope that you will understand my meaning). By this, I mean that even small events or factors may have profound consequences. The right person being in the right place at the right time, a decision of bureaucrat, a rumour - all of these offer opportunities for dramatic changes in the situation. In other words, there will be a period of huge instability, and that instability creates opportunities for small events to have profound consequences.

As you may gather, I am profoundly worried by the current situation. I was able to predict this crisis, but was not able to predict the way in which governments would react. The way they have reacted is a way that will ensure that the crisis leads to economic disaster. In choosing to try to borrow their way out of trouble, in failing to reform their economies to lower costs and prepare the way for real wealth creation, they have sent a message to their creditors. That message is that they must continue paying for the comfort of the Western lifestyle, at the cost to their own people, or they must face the consequence of massive economic upheaval, and consequent chaos. I believe that creditor governments will be trying to work through this question, trying to see how this can all end. I can not be the only person raising these questions. At some point in time, the complete lack of logic in the current situation must come to an end. There is no way that the creditors to the West can be happy to be supporting the Western economies, with little prospect of ever gaining any return. At some point, it just must come to an end.

I am sorry for such a gloomy post, but my aim has always been to try to analyse situations in as realistic way as possible. For new readers, there are many points in here that require deeper explanation, such as the role of commodity supply in the world economy. You may want to take a look here to understand why the situation is as I say it is. You may also want to take a look at the other posts that I link to at the top left side of the blog. This all may sound like an extreme take on the situation, but there is a disturbing logic in this analysis to be found throughout this blog. Even as I write this, it is a sunny day, and the world outside appears normal and unchanged. The best way to understand how deceptive this calm might be is to imagine the tourists sunbathing on the beaches of Phuket, just before the Tsunami struck. In a matter of minutes, their world was turned upside down.

Note 1:

Ishmael asked the following question:

'My question was in regards to the system of fractional reserve banking and the criticisms that have been made in a few documentaries especially "money as debt" and "zeitgeist" and "zeitgeist addendum"

This article can explain the debate better than I.
http://en.wikipedia.org/wiki/Criticism_of_fractional-reserve_banking

I was wondering on your opinion on this matter as my financial knowledge is a little basic, Is a crash inevitable or is there another mechanism at play that mitigates the effect of exponential debt plus interest?'

I have not seen either of these documentaries, but I do discuss fractional reserve banking and my post on the subject can be found here. It is a rather unusual perspective, but if you stick with it, I hope that you will find it interesting. My article on government borrowing and interest rates may be of interest as well.

Note 2: An anonymous poster has mentioned how easy it is to make fake coins, in reference to my cynicism about the Amero conspiracy theories. Thanks, for the contribution, which is helpful.

Note 3: I have the following from an anonymous poster (edited):

'I know the idea is to get the banks and mortgage providers lending again, but they cannot go back to lending to people who will never be able to repay the loan.(sub prime)

With the economy about to take a dive, (and I suspect never to recover to pre crash levels) what sort of an economy will follow?

The only exponential growth in the Western world is people, Britain (and America's) populations are rocketing and it is my guess this is where the growth is to be conjured, as I suspect it has for the past eleven years. '

The answer to this is relatively simple and also terribly complex. The one certainty is that the economy of Western countries will be considerably smaller. As to what kind of economy, that is the complex question. Increasingly socialised, protectionist, or lean and mean and ready to face the competition in the world? That, to a large extent, is in the hands of the politicians and where democracy is in play, that is in part in the hands of each individual with a vote. Will the voters look to the state to 'fix' the problems through protection, endless state interventions, or will they decide that they want to regain their place in the world? This ceases to be a question of economics, but becomes a question of politics.

Note 4: A very late reply to Phil (apologies)

I’d like to offer a further point of reflection: while in the West we continue the “Debt Economy Delusion”, what the biggest producer of real wealth - China - will do?
12 October, BBC News website had an article, “China agrees land reform package”.
The article quotes Xinhua news agency:
"The Communist Party of China Central Committee on Sunday approved a decision on major issues concerning rural reform and development," Xinhua said.
Its commentary added: "The global credit crisis freezing up the world's finances may be a blessing in disguise for China as it aims to modify its economic structure after three decades of breakneck growth."
My take is that, as the global crisis will restrict external demand for Chinese goods, China will expand its internal market, the biggest single market of the world.
And what will happen then, monetary speaking? Will the Yuan increase its (now artificially lowered) value?
And, as we are at it, what will happen to major world currencies?

This is a very interesting comment. The RMB will certainly have to significantly increase in value, at some stage or another. I tried to keep my own money in RMB for that reason, but holding money in China is problematic. There are many possible drivers for a large upward revaluation, including threats of protectionism, and it is difficult to say when the CCP will allow a major revaluation. Add into this mix the questions about internal stability, and what might happen if China falls into recession, and life gets more complicated.

One of the interesting things about an artificially low currency is that drives economic growth through export led growth, but at the cost of the relative wealth of all the individuals in that country. To give an example, a Gucci bag may be significantly more expensive than it otherwise might be with a balanced exchange rate. That differential means that, in real terms, the potential purchaser of that bad in China is poorer. In short, the people in the country do not get a 'fair' price for the imports that they buy. If you look at it this way, China could overnight become significantly more wealthy, just by revaluation. However, in doing so, could they maintain their economic growth? It is not certain at the moment that this is, in any event, possible. It really is a very complex point. How much of China's success is due to the artificial currency rate? I am not sure on this, but think that it is significant a factor. However, the cost of this approach is now coming at them through the back door, through the damage that the undervaluation has helped create (unbalancing the world economy).

As you can see, a very involved answer, and one that illustrates the inter-connectedness of the world economy. I think I have already answered the questions on currencies in the main post, so will not answer that question further.

Note 5: Another anonymous poster asked this:

This whole business has led to a potential cataclysmic political sea change.

Is neo Liberalism dead in the water?

The ramifications to the answer to this question is mind boggling.

If the answer is yes - What next?

I have answered one of the questions in the main post. Neo liberalism dead? Another one for the politicians, I believe.

Note 6: Hilly asks the following:

'Is the extent and volume of the losses incurred internationally (100s of billions of $) simply due to this over-lending, over-valueing, over-selling etc.. not just in housing (which does incur the losses) but in the levels of borrowings bothprivate & commercial that are being defaulted currently or are anticipated to be so, plus governmental overspending of future incomes?'

I am not sure I grasp your underlying question here, but if you can clarify it, I will try to answer it (time allowing).

Note 7: In reply to a question below:

It's just occurred to me. (I'm not the sharpest tool in the shed) Are we, (West) in the absurd position of being lent money by China to enable us to buy their goods?

It's a sort of merry-go-round that could continue for ever.

This is something I have discussed previously in this blog. You are absolutely right, except about the ability for this to go on forever. The lending will only go on as long as the lending creates a return. As soon as the returns diminish, the merry-go-round stops. It was an unsustainable economid model and part of what we are seeing is the collapse of this model. It was not just China, but all of the creditor nations who have funded the West to buy their products. It sounds mad when you think about it, but this is why I make the Aristocrat analogy. Think of the situation where the aristrocrat buying his tailoring on credit.

Note 7: More questions (see below). I only have a little time so I will just answer a couple of those raised (all too briefly). Answers are in italics.

'The economic backdrop to the 21st. century is the mantra of ever increasing growth in a world of diminishing supplies of raw materials. (is this the same as your commodities?) The production of raw materials (commodities) relative to demand are decreasing even though output in absolute terms has increased. See post here.

Where has all the money gone? Has it been consumed on trips to Disneyland, McMansions, SUV's, snowmobiles, second homes, etc.etc. The short answer here is yes. Much of the money has gone into consumption, and therefore has been spending now at the cost of foregoing future wealth.

With the present arrangement of China having become the workshop of the world, they have amassed shed-loads of dollars amounting to hundreds of billions, what are they supposed to do with this mountain of money? Not hundred of billions but fast heading towards $2 trillion. That is one of the problems that they face (and other creditors are facing). The West is not producing enough of what they want to buy at a price they are willing to pay. That means that the value of the currency must devalue. Once it is no longer used to fund Western borrowing, then there is no demand for the currency, and the value of the currency falls.

The only thing they can do with it is lend it back to the West or buy up Western assets as investments. Yes, see above. But they will no longer want to lend it, as their little prospect of the ability of the West to repay. We are not making enough goods that they want etc. (see above answers). This is one of the points in the above post, so I think I will need to rewrite it, to better explain this.

With the World's dwindling resources I cannot see manufacturing returning to the West, which again prompts the question, where is the wealth generation to come from? Please do not buy peak oil and the rest of the scare stories out there. oil must peak at some point, but there is no firm uncontested evidence that resources are dwindling, and peak oil has been predicted since the 1930s. It could be now, or it could be later. I was posting months ago that oil would drop to $60 when the peak oil believers were predicting $200. Last time I checked it was at $75. Overall demand has outstripped the ability for suppliers to meet the demand, but demand is now falling back as the Western economies contract. Again, see post here. The main problem is bottlenecks, not the amount of material (a curious example is the inability to produce the huge tyres for the monster trucks used in open mining)

As an aside, how can the West (Britain) embark on an economy of manufacturing when the have just announced another round of cuts on carbon emissions? Expect 101 ways for this to be quietly abandoned in the coming years. I think that you will find hard times will diminish the enthusiasm for action which damages economic prospects.

Naive question perhaps, what is the difference between borrowing money and the government printing its own? In other words why borrow when you can print it? This one is not a short answer, so I will (time allowing), try to address is another time. The simplest answer...Both options are bad, but printing money is worse.Not a naive question, but a very good one deserving a proper reply.

I am afraid that time has run out (explaining the rushed responses above). I will try to put more time to answering questions but must balance my limited time against the general posts. As such I will do my best to keep answering as many comments as possible.

The Bailout - Foolishness Triumphs

Are you a first time visitor to the blog? If so, then you might want to visit here if you want to understand what is really going on in the world economy. If you doubt the credibility of blogs, you may want to read my (rather long) essay here, and hopefully this will help give the rest of what I write some credibility. Main post continues below.....

After many false starts (including on this blog) it looks like the bailout has finally passed. It took a considerable amount of 'pork barrel', but it has passed (does anyone know the origin of the expression 'pork barrel'?). The fact that it required the dishing out of pork barrel is, of itself, a telling condemnation of both the bailout, and a system that is built upon delusion.

I will not restate my arguments against the bailout, as I have covered this from many angles in previous posts (click here for one example, in this case the 'common sense' argument). However, I will just raise one point in the Telegraph article on the bailout:

'But Mr Bush cautioned that "it will take time before the legislation's full effect on the economy" was felt. Acknowledging public concerns about the sums of their money that will be spent, he expressed optimism that the "tax dollars we invest will be paid back".'

There is a simple answer to this optimism. Why, if these assets are undervalued, are the sovereign wealth funds and other sources of finance not snapping them up at their distressed valuations? They stand to make a killing if they are undervalued, and they have the necessary capital to buy them.

Now that the bailout is being enacted, what happens next? According to the FT (sorry no link) the initial reaction was further falls in US stocks, which goes against the script of what was supposed to happen. Not being within these markets it is is difficult to see how sentiment will move. However, if there is a rally in markets, it will be short lived. It is just a question of weeks, or a couple of months at most, before it becomes apparent that the magic wand of borrowing will not solve the underlying problems in the US and UK economies.

The New York Times, for example, reports that in the 9th month in a row there have been job losses in the US, with September seeing a loss of 159,000. In the same edition, a commentary points out to those who are enjoying the discomfort of bankers that the bankers will take the rest of the economy down with them. As usual, they are getting it the wrong way round, in thinking that the financial system is taking the economy down, when in fact it is the economy outside of finance that is causing the problems within finance (although they are both in mutual feedback systems).

As an interesting note, over the last couple of years, I have been reading several articles in the Economist pointing out that, in the US, many states are also in deep debt. In other words, it is not just the federal government that has been loading up on debt. I have just seen an article that reports that California may need to turn to the federal government for finance. If the Economist reports were correct, this is the first of many. As such, on top of servicing the federal deficit, bailing out the financial system, it is likely that there will be more call for federal aid to the States in the coming months. In one of my previous posts I linked to an article that suggested that the US government was insolvent. In the coming months I think that this idea will be tested.

Meanwhile in the UK, the John Lewis Partnership reported a dramatic fall in trading (a bell weather of middle class spending), there are reports of shrinkage in the service sector. I predicted an end to the service economy, and the result is going to be very ugly indeed, as it constitutes such a large part of the economy. Meanwhile the UK government has extended the deposit guarantee to £50,000, a rather pointless move as it is not enough to restore confidence whilst exposing the government to greater liabilities (regular readers will know that I do not support such guarantees in any case).

Around Europe, the crisis plods on with its own momentum, with the Icelandic boom turning to bust, more and more banks falling over, and so forth. I will not bother listing all of the bad news, and will just point out that it is just one problem after another emerging.

Regular readers will know that I do not just post rehashes of the latest news, so I should come to the point that I am trying to make here. Kecske has left a comment with a link to a very interesting article in the Guardian (thanks for the link, by the way). In my last post I discussed how the 'mainstream' of media, economists, bankers and politicians just do not 'get it', by which I mean understanding the fundamental change in the world economy. In the article it is very clear that China is calling the economic shots and, reading the subtext, it is clear that there is a sense of shock, as people are finally waking up to the shift in economic power.

In other words, the delusions are starting to evaporate. It is becoming very clear that China is winning the economic race. Whilst it is still not a wealthy country, it is racing to the top, and that it is a zero sum game - China is rising as the West falls. In the news I have posted above, I have given some examples from the news that illustrate several points.

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...

So it is with the belief about the US and UK economies. We can see the growing competition from places like China in the abstract, but we still insist on our generous welfare and benefits, and insist on loading costs onto our economy. We simply do not believe that we can fail. But we can.

As I look at the potential new leaders on both sides of the Atlantic, I do not see anyone who has yet given any indication that they have the courage to deal with the reality of the economic crisis. I do not hear from any of the politicians serious consideration of real reform, reform of the kind that is needed to return the economies of the US and UK back to competitiveness. All I see is more burying of heads in the sands of easy solutions, of borrowing more money when the answer is cutting back and repayment of the debt....in other words facing the reality that our infrastructures are like that of Ford, that they are bloated and will eventually destroy the source of wealth that we take for granted.

The Economic Crisis - The Bailout and Other News

Yesterday, before I read the latest news on the bailout, I made my regular visit the various financial sections on the online news services. I was struck by one of the finance home pages, in this case the Telegraph. I would link to the page, but the page changes daily. Why would this page be of interest. Fortunately I left the page open, and here are a selection of the headlines:

'Mortgage Lending Plunges 95pc as market "Decimated"'
'UK high street banks may benefit from US bailout'
'City has B&B concerns'
'Airbus Launches in China'

Today, in the same paper, the headlines are as follows:

'US Markets in Freefall as Bailout Rejected'
'Banking crash hits Europe as ECB loses traction'
'Banks to absorb B&B losses'
'Benelux states part nationalise Fortis bank'

Why am I giving this list of headlines? The reason quite simply is that, within these headlines are expressions of the roots of the problem. As I viewed the above headlines I came across a quote from Gerard Barker of the Times as follows:

'If Congress wouldn't listen to Bush and Paulson it might at least listen to the markets'

It is a fascinating quote in light of the above headlines, because there is a fundamental disconnect in the thought. Gerard Barker is assuming that the real market is what is happening in Wall Street and the City. He is missing the point entirely. The real market is the market of the day to day decisions and activity of billions of consumers, and endless millions of companies supplying goods and services, and the choice of where real wealth creating capital is allocated. It is they that drive the markets, not Wall Street, and certainly not governments.

The City and Wall Street are just a reflection of the reality of the situation on the ground. The banks are not failing because of the lack of a bailout, but failing because of the damage in the wider economy. Even before the current crisis, the CBI survey of financial institutions in the UK found that the banks were suffering from plunging profits. This is the reality of the crisis, that both consumers and businesses were hurting, and that the result was that the banks were looking at ever more pain as a result. With consumers not borrowing, banks not lending, consumers not spending, and therefore businesses suffering, the banks are in trouble. What that actually means is that, on the ground, away from the world of finance, there are real problems. It is the downward spiral that occurs when the credit ATM shuts down. I have said it before, but the bank balance sheets will be looking ever more ugly as each day goes by, as consumers increase defaults on both mortgage and personal debt, and as commercial debt goes sour.

In other words, there is not some mystical force in Wall Street or the City driving all of this, but fundamental and deep economic problems. If the fundamentals of the economy were good, there would be no banking crisis. Companies would be generating profits, and consumers would not be defaulting on their loans, and the house market would be buoyant.

If we return to the above headlines we can see an illustration of one of the problems in the article that details the opening of an assembly plant in China by Airbus. Such an action would have been encouraged by the Chinese government, as a way of ensuring access to the growing market for aircraft in China. Airbus, in opening such an assembly operation, will ensure that China will emerge as a competitor in aviation in 10 years time. Once embedded in China, the process of sourcing components and parts locally will commence, and local Chinese companies will be taught how to serve the aviation market and, once they have learnt, will expand into broader international markets. As more and more suppliers are able to meet the high standards and technology required to build modern aircraft, the infrastructure will be put in place for a Chinese competitor to emerge. This process has been going on for many years, in many sectors. It is the combination of capital, access to markets, access to technology that I have discussed in my previous posts in the abstract.

This is the reality behind the financial crisis, the emergence of competitors who are taking ever larger shares of world trade. They are producing goods and services in competition with the OECD countries, and they are doing so ever more effectively. For those who still insist that it is just cheap labour, I would suggest that you listen to the following from an Economist report on globalisation (Economist Print Edition, September 20th-26th, 2008, p 12):

'Being Willing to match India's low-cost model was essential, but Mr. Cannon-Brookes insists that IBM's enthusiasm for emerging markets is no longer chiefly about cheap labour [...] Perhaps a bigger attraction now, according to IBM, are the highly skilled people it can find in emerging markets'

The reality of the markets is that we in the West have deluded ourselves that we have the better people, the better technology, the better infrastructure. Perhaps we still do, one of the points made in the Economist article, but the speed with which such advantages are diminishing is shocking, and in any case the advantages pertain to an ever smaller part of the market (the part of the market that requires only the highest levels of technology, process and know-how such as aircraft manufacture). In other words, globalisation is setting about a complete restructuring of world markets, and that restructuring is about moving business to any place where there might be any competitive advantage. This again, is the reality of the market.

Every time that a consumer enters a shop to purchase something, they are the drivers of the real market. Every time a business seeks a supplier of a component or service, they are the real market. Every time a company allocates capital, this is the driver of the real market. The financial institutions of Wall Street and the City may imagine they are in the driving seat, but the reality is that they are just responding to each of those tiny market signals. This is not to say that they have no influence, as they allocate the capital that is available, and have allocated it very poorly, leaving insufficient capital for investment in productive activity in the OECD (real wealth generation), but they still are driven by the activities of the real market.

In the current situation, the problem is that they lent to the wrong places, consumer and mortgage debt. They miscalculated, they failed to realise the real source of wealth is in manufacturing products and supplying services to support that wealth generation. They thought that debt = wealth, the fundamental point in 'A Funny View of Wealth'.

The purpose underlying this post is to reiterate that, for all of the excitement about the state of Wall Street and the City, they are really not what matters. If the underlying economy were healthy, then all of the lending to consumers that is driving the banks to bankruptcy would not be going sour. It is the underlying weaknesses, the lack of wealth generation, that means that the debt is going sour.

When we view the world as it is, instead of through the delusional filters with which we have viewed the world, it becomes apparent that the bailouts would never have worked and would just be another burden on economies that were in any case less and less fit to compete. The question that needed to be asked about the bailout is whether it could actually change the underlying reality of the economies that really drive the financial system. In other words, would the bailout do anything to create wealth? At some point wealth must be created to pay back the debt, and the bailout was just transferring debt from one place to another. It was not solving any real problem, but just shifting the problem to another place. The only solution to the real problem is for the OECD countries to respond to the real market, and that market is one in which tough competitors have emerged, and who are fast moving up the value chain.

It is for this reason that in a previous post I call the bailout a 'magic wand'. It is for this reason that I have opposed the bailout. It is just a way of pretending that the real problem is not there, of pretending that the world has not changed. It is just a continuation of the delusion.

No doubt, some readers would have expected me to discuss the events of the last few days. I hope that, having read this, you will see why I have not discussed the blow by blow saga of B&B or Fortis, or the failed bailout. They are events, they are important in their own way, but they are just a reflection of something more important. The market is readjusting, and the banks are just following the 'real' market (or at least the real drivers of the market - individual choices in the selection of goods and services) in the readjustment, albeit accepting that they are one part of that market.

I have had a comment from 'Souza', which questions some of the ideas that I have put forward. I will quote Souza in full, as he puts forward some interesting points:

'Having immigrated from an "emerging economy" to a "rich country" I experienced this phenomenon first-hand, but the explanation always seemed obvious to me: rich countries are rich because of currency imbalances. Much of the wealth of rich countries is founded upon (and funded by) artificial exchange rates. The answer to the "cigarette lighter problem" is that the New Zealand dollar is overvalued against the Chinese yuan by a factor close to the ratio between the prices of the lighter in both countries.

The fundamental question is not "why the lighter costs more in New Zealand", but rather "why the income of workers in different countries is not commensurate with their productivity". I don't know the exact figures, but I'm quite sure that a convenience store clerk in New Zealand earns at least 10 times more than one in China, despite the fact that the productivity of both workers is roughly the same. As I said, I experienced this first-hand when I moved from one country to another and saw my salary instantly multiplied by 4, despite the fact that I have not become any more productive.

So when you say that "something is very wrong and unbalanced in the world economy", I say "it's the exchange rate, stupid!". (I hope you recognize the "stupid" as an allusion to a commonly used phrase, not an insult). And even though I'm sure there is a lack of balance, I'm not sure it's necessarily wrong, for the simple reason I don't fully understand where it comes from.

The one thing I can be quite sure of is that exchange rates are a matter of supply and demand, so the currencies of rich countries can only become overvalued by creating artificial demand for them. And the most obvious way in which I see this happening is through cultural influence. To take but one example, the fact that Coke is so popular in almost every nation on the planet is highly beneficial to the American economy, but such a high demand for a product with little intrinsic value can only be created by cultural influence. Surely if exposed to it without the accompanying marketing machine, most people would find the taste of Coke between trivial and repugnant (it is, after all, nothing more than water, sugar, and CO2)

This is a complex topic and I have no room to expand on it, so I'll finish with my opinion on the future of the wealth of wealthy countries: there is not much to worry about, things won't change much. The current state of the world's economy is a product of politics and culture, not of worker productivity. A "service economy" is perfectly sustainable for as long as there are far more poor countries in the world than rich ones - a situation not likely to change in any foreseeable future. The most visible result of the "service economy" is that it creates a world market for things people in rich countries are no longer willing to manufacture; things such as cigarette lighters.'

He is right to say that the currencies are overvalued. This is a point I have made throughout the posts, and why I predict that the 'rich world' currencies must drop against those of the emerging markets. This represents a real loss of wealth, as the commodities that are purchased will be more expensive, and the goods imported will be more expensive, the holidays that consumers take will be more expensive. A simple and crude way of looking at it is that a consumer will have to work x number of hours more to buy a Japanese branded, manufactured in China, plasma TV than they did before. This is a real loss of wealth. In answer to this point, yes, the currencies will drop, and every individual in the 'rich world' will commensurately poorer. I also agree that currencies are dictated in the long term by supply and demand. A large part of the demand for Western currencies has been driven by demand created by foreign institutions to invest in rich world economies, either to buy companies, or to lend into consumer markets. Now that such demand is falling, there will be ever less demand for the currencies. The currencies will fall. The rich countries (excepting some like Germany) are just not producing enough products that other countries want, and the result is that, without the demand for currencies for (now revealed as foolish) lending into the economies, there is little support for the current value of the currencies.

With regards to the salary differentials, that is the underlying point about the 'Cigarette Lighter Problem'. How can this differential be justified? Somewhere in the economy, there needs to be sectors that are generating huge amounts of wealth to pay for the salary differential between the Chinese shop worker and the New Zealand shop worker. Where is this wealth generation coming from. We can look for it, but it is impossible to find such a massive source of wealth (see 'A Funny View of Wealth' for my attempt to find such sources of wealth in the UK). As such, what is paying for the differential? My argument is that it is debt, lending sourced from outside the country, that is paying for a large proportion of the differential.

The Coke example is an interesting one. Coke has many meanings attached to it, not least of which is the association with the US lifestyle, the US dream and US culture. What happens to Coke when the dream goes sour? Coke is a great marketing company, and therefore will probably adapt their image to the changing circumstances, but their value at present is tied up with the culture and values of the US. There still remain in the West many great companies, but these companies are facing ever more, ever better competition. I remember sitting in front of a Unilever executive telling me about the fierceness of competition from local suppliers. Unilever were holding their own, but the battle was tough. Unilever is an example of the very best of Western companies, so what of the weaker companies?

As for the last point made by Souza, I am hoping that the post overall will have answered the suggestion that as long as there are poor countries, the service economy can be sustained.

Anonymous made the following comment (and question):

'I don't know if you are still in China, but I am! I wonder what it would take for all this to start to 'undermine' the Economy here? Is there some event, some process that is unravelling? Elsewhere people have said this is not a 'Global' crisis, just an OECD and particularly US/UK one. To what level might the Euro/GBP actually fall against the Renminbi? You say that is the easiest of the 5 options to be enacted? But would that actually help..and help who?? '

There are many points here, but I will focus on who the devaluation might help. I would not suggest that the devaluation would 'help' anyone. It is a market process that is inevitable, but is not imbued with any intentionality. It is not happening for a purpose, but because market forces seek (again with no intentionality or purposefulness, despite using a verb that suggests otherwise) an equilibrium. The mis-allocation of capital created an imbalance for so long, but eventually the market had to snap back into a balance. In this case the trace balance was pulled out of shape, and the correction is a rectification of this imbalance through currency changes, and the destruction of the value of the Western currencies is the correction.

I hope that the above is clear, as I am somewhat dissatisfied with my own answer here, and am not sure I have expressed it well. Let me know if it does not make sense.

There is much more that could be said in this post, as well as some other comments I would like to respond to. However, time is short, so I hope the other commentators will forgive my lack of response.

I also hope that this post will go some way to directing your attention away from the minutae of events, and help to focus on the bigger picture, which is what really matters.

Banking Crisis - More on Government Intervention

Another post, and I am afraid even more rushed as my 'real life' is rather busy at the moment. For the sake of my credibility, new visitors to the blog might want to read here first, as they will see that I have predicted the current crisis. You may also want to follow the links to key articles given on the left, once you have read these posts.

There is ever more fascinating news as the market has once again swung upwards in a fit of optimism. The reason for the optimism by the FT is as follows (not sure whether the link above to the FT will work):

'At the core of the plan is the proposal to create a government-sponsored vehicle loosely modelled on the 1989 Resolution Trust Corporation, which would take on the toxic assets in the financial system, allowing banks to stem their losses, recapitalise and return to business.'

The cost of the bailout for the US government, according to a Telegraph report, is up to $1 trillion, with Hank Paulson, the US Treasury secretary, suggesting that it would initially cost '$hundreds of billions' (see earlier FT link).

On top of this, short selling is now being banned accross stock markets. Happily, at least this rather silly action has received as much criticism as praise, so I will not add to the comments on this subject, except to refer you to my previous posts. Unhappily, the criticism is falling on deaf ears.

So what does this all mean? Has the financial crisis been solved? I think that, at best, the crisis is now on pause. The real difference here is that the nature of the crisis may have altered. I have said in my previous posts that the problem with such bailouts are twofold:

1. The bail outs are shifting the economic damage onto government balance sheets at a time when the governments of the OECD will need all the resources that they can get. As the world economy rebalances the Western governments will need to make structural adjustments to meet the challenges of the emerging economies, and the massive input of labour into the world economy that they represent. The bailouts will tie government finances in knots, and may actually precipitate a loss of confidence in the ability of governments to pay their debt obligations.

2. In taking on the damage from the financial system, governments are spreading contagion throughout the economy, including the healthy parts. This is due to the inescapable fact that, at some point in time, the healthy parts of the economy will be facing larger tax bills.

Notwithstanding the above two points, can it possibly work? The only way to answer this question is to look at what really caused the crisis. Most analysts now accept that the debt bubble that has been built up over the last ten years was wildly irresponsible (it is amazing how they are so clever with hindsight - those who have read my essay 'A Funny View of Wealth' and this blog will know that I am not talking with the benefit of hindsight). However, what the analysts have failed to understand is that the debt bubble has just been hiding the underlying structural problems in the Western economies. That is that their cost base is too high, and that their competitive position has been eroded by the massive entry of labour into the world market. What they do not realise is that the credit bubble not only hid the need for structural adjustment, but has crippled the ability of the bubble economies to make the changes.

The most worrying part of all of this is that, in the downward spiral, government finances in both the US and UK were always going to be in trouble, as I predicted in a 'Funny View of Wealth' as follows:

'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, they will be faced with ever more expensive borrowing, meaning higher interest rates, or massive cuts in public expenditure. There will be no room to manoeuvre. The only solution will be to cut back on expenditure. Continuing to borrow will be too expensive, and would destroy the value of the pound, as well as creating an even deeper crisis of credibility that the UK government can manage the economy. As the government is forced to cut back, many of the new state sponsored jobs that have been developed over the last ten years will start to disappear. This will not impact immediately, where funds have already been allocated, and contracts remain, but the process will accelerate over time. Some regions, such as the North East, will be hit very hard, as their economies are largely dependent on the state sector. ' (written in November last year)

I later suggest in another post that the UK will need to go to the IMF for funding (but recently have started to wonder who will fund the IMF?). I have noticed over the last few days that there is news that the deterioration of the finances of the UK government is accelerating. As an example, the Times report as follows:

'Fears that the Government’s finances will plunge into the red to an extent not seen for decades as the economic downturn deepens were fuelled yesterday as Treasury borrowing last month rose to the highest for any August in 15 years.

Borrowing by the Chancellor, to plug the gap between still fast-rising government spending and faltering tax payments hit by the downturn, jumped to a net £10.4 billion for last month – the highest August figure since 1993 – official figures showed.

The worsening state of public finances was emphasised as the latest leap in borrowing raised the Government’s deficit for the first five months of this financial year to £28.2 billion, up from £16.5 billion for the same period last year. It is a record for this period in any year since the early 1990s.

City economists sounded warnings that if this pace of deterioration were to last for the whole of the 2008-09 financial year, then Alistair Darling would see his borrowing soar to between £60 billion and £70 billion – above his planned total of £43 billion.'

Addition added after the original post but same day as original:

I have just read a fascinting and disturbing (but unsuprising) article in the Spectator regarding PFI:

'How did it come to this? As trauma continues to course through the global financial system in the wake of the Lehman Brothers crash, the PM and his colleagues reassure us constantly that Britain is ‘well-prepared’ to withstand the shock of economic crisis. In fact, the opposite is true. It is a basic principle that most governments, even socialist ones, pay off debts in times of prosperity. Mr Brown’s innovation was to reject this tradition. Since Labour came to power, the national debt has risen 25 per cent to £581 billion. During the second it took you to read that last sentence, it rose by £1,520 — and that’s by the government’s more optimistic measure. This figure does not include the layers of hidden debt, or the various IOUs made out in convoluted ways on behalf of the unsuspecting British taxpayer.' [referring to PFis]

And

'While this will help make an important post-election point — the malfeasance of the Labour years — it carries an obvious risk. Should Mr Osborne pull all the pieces together and take all PFI on to the books, the new Tory government will have to disclose to the public a debt burden higher than seen by any administration since Britain had to be rescued by the International Monetary Fund in the 1970s. Confronting such debt will deny him any room for manoeuvre.'

The article calculates national debt at £26,100 for each British household. I strongly recommend that you read the article in full. I pointed out the danger of the PFIs in 'A Funny View of wealth', and I think in later posts too. This article puts some meat on those bones, and explains the scope of the problem (I believe I used IFS figures that were out of date when I looked at this, and the situation has become far worse).

Original post continues.....

My worry is that these figures are conservative [not the Spectator - original post]. For example, I have seen the predictions for UK GDP growth in the Economist magazine poll of economists drop, point by point, as the current crisis has emerged. In other words the economists have still not grasped that we are in a game of financial Kerplunk, where each day a straw is being pulled, and each day that passes brings us closer to the marbles falling down. They have not understood that all of the 'economic growth' of the last ten years is built upon debt, but not that the UK economy (and the US) need to jump back in time such that the economy will return to the size of 10 years ago. However, that is not the end of the problem.

The environment of today is more competitive due to the emerging economies, and the massive pool of labour (in conjunction with capital and technology that they represent). Furthermore, the government has taken on ever more debt, and the ability of the UK economy to service that debt is built upon the current (misunderstood) level of GDP. The illusory growth is now being seen as such, but the implications are still not understood by mainstream economists.

At this point, we need to play a game of 'what if...', in this case 'what if we had never had the housing and credit bubbles?' Such 'what if' scenarios are always dangerous as an illustration of a point, but I hope that you will indulge me on this.

The first point to make is that the massive expansion in retail and service industries would never have occured. Without the financing of the credit from the East into government and consumer debt, the economy would have stagnated, unemployment would have risen, and the UK would have probably fallen into recession. Government spending would not have ballooned, as the government could not have afforded so much growth without massive increases in taxation, and the rise in the living standards of the ordinary people of the UK would have stagnated. The increase in house prices would never have happened. The massive boom in imports would not have happened, the boom in the city would never have happened, the value of the £GB would have gradually fallen back, thereby slowly correcting the imbalance between the UK economy and the emerging economies, though a fall in the value of the £Gb would have literally meant that each person in the UK would have been progressively a little poorer. The result is that the entire cost structure in the UK would have gradually rebalanced to reflect the new economic conditions of increased competition in the world. It would not have been a pleasant experience, as no one wants to become poorer, but it would have been unavoidable.

This is the scenario of what 'should have happened' but how the government might have reacted to the scenario is an unknown. When we think of the economy without the credit boom, it becomes apparent how bad things are now. However anyone tries to pitch it, when we take away the growth in debt, there is little left but pain. The difference between the scenario I have given now is that the credit bubble has happened, and it has left the UK and the US economies in a terrible position where they are really unable to make the adjustment as, on top of what was always going to be painful, they have the additional strains of their massive indebtedness built upon false confidence in the ability to repay, and economies that are day by day shrinking back, such that they become ever less able to repay.

When we bear all of this in mind, the bailout of the financial system looks ever more foolish. The US govenrmnet is not just bailing out US investors and the US banking system, but the entire world banking system. Quite simply, the US can not afford to do this. As I have said before, the governments of the US and UK desparately need to gather what resources they have left, massively cut back on expenditure, and set about the reform of the structure of their economies. The US (and to a lesser extent the UK) still thinks it is the financial giant responsible for the world economy, and that it's role in staying on top is to manage the world economy. This is delusional. It is built upon an assumption that it has a right to wealth, that it has a natural place at the top of the economic tree. This is a point that I made in one of my early posts in reference to the UK. I had this to say:

'I read a very interesting example of this kind of thinking when I was reading some philosophy of science (sorry, I forget where I read it). The example given was a chicken that woke up every morning, and every morning the farmer fed the chicken. As a result the chicken believed that the farmer was a good thing - right up to the point where he chopped off the chicken's head. In the same way we have come to believe that the UK has some right to have the status of being a wealthy and successful economy. It always has been in the past, so why not now? The truth is that a successful economy is not a 'right', but something that has to be earned.

The trouble with the UK is that we expect wealth as a 'right''

The simple truth in all of this is that wealth is not a right, but something that must be earned by competingly effectively. That can be achieved by working harder, or working smarter. It can not be achieved by just expecting it as a 'right'. We have, for so long, been the only players in the game we have forgotten what it is to compete, and we have seen the emergence of strong and agile competitors for which we are completely unprepared. Had we faced this competition ten years ago, we could still have emerged as strong players in the world economy. Instead, we faced the competition with complacency and so now face stronger competition with one hand tied behind our backs.

I have suggested reforms to the structure of the UK economy (see links top left of the page). In light of current events, perhaps these are too mild and in any case still may be unaffordable. I can only reemphasise yet again that deep structural reform is the only way out of the current mess. Bailing out the financial system will just make the reforms ever more difficult.

As for the upsurge of optimism, historians who have studied the Great Depression will tell you that there were similar false dawns at that time (sorry, no time to reference this). As such, as for the last upswing in confidence, I will repeat what I said following the nationalisation of Fannie Mae and Freddie Mac:

'It will be interesting to watch the reaction to the nationalisation in the coming weeks. I suspect there will be a brief bounce in confidence, but that the underlying economic problems will quickly dent that confidence. The trouble is that there is no escaping the reality that there must be a massive rebalancing in the world economy, and no amount of intervention can stop that process. In such circumstances, it is quite possible that, in the long term, such bailouts will only create more pain than gain.'

In other words, we are back to waiting to see when sentiment will once again turn, as the reality of the situation intrudes on the optimism. I keep asking myself when will everyone wake up to the fundamentals of the problem???

Note: I forgot to mention. Goldman Sachs appear to be next in the firing line. Will the ban on short selling save it - I think probably not, but do not pay that much attention to the condition of individual institutions.

Note 2: On rereading this post I see I have once again jumped about in the post, moving from the very general, to the specific to the US, to the specific for the UK. I hope you will forgive this stylistic blundering, but my 'real life' is making demands, such that I do not have time to correct this. I hope that the post is still clear.

Note 3: I forgot to mention. One of my original intentions in this post was to highlight the absurdity of one individual teetering on the edge of bankruptcy lending to another person teetering on the edge of bankruptcy. Would it not be better for the individual to use the remaining lines of credit to buy time while they sort out their own financial problems?