Iceland and the Banks

Recent news on Iceland is that the ratings agency Fitch has now determined that Icelandic debt is safe:

Fitch raised Iceland's sovereign rating by one notch, to BBB- from BB+, meaning that the country's debt is now "investment grade".

Iceland's economy imploded under a mountain of debt in 2008, forcing an International Monetary Fund bailout.
Since then, the debts of its neighbours have sparked a crisis in the eurozone.

Fitch said the decision "reflects the progress that has been made in restoring macroeconomic stability, pushing ahead with structural reform and rebuilding sovereign creditworthiness".

In 2008, its three banks failed under their enormous foreign debt, which at one point was larger than the Icelandic economy.

The value of the Icelandic krona plunged, which made its exports more competitive. The new government of 2009 was allowed to carry on borrowing and spending for another year before spending cuts kicked in.

Ignoring the uselessness of the ratings agencies in general, the upgrade is a response to the positive trajectory of Iceland's economy. In 2011, the previously devastated economy grew by 3% overall, and unemployment has fallen by over 1% since 2011. I say previously devastated, as Iceland (as I am sure you will all remember) had the most almighty banking meltdown (in relation to the overall size of the economy). However, when confronted with the lunacy of the debts racked up by the banking system, Iceland did something very different to the majority of economies when confronted with bank failure; they did not bail out the banks.

The rather odd thing is that the sky did not fall upon Iceland, there was no apocalypse, and now the economy is in recovery mode. It should be remembered that, as its financial system collapsed, Iceland went to the IMF for a bailout. The purpose of the loan, was as follows (from the IMF):

The program had three objectives: to stabilize the exchange rate, put the public finances on a sustainable path, and restructure the financial system. All three of these objectives were met by the time the program expired. This was really an enormous achievement, given the severity and depth of the crisis that Iceland faced at the time.

The exchange rate had depreciated sharply in the run-up to the crisis, and there was a deep concern that it would plummet in a disorderly way. This is why capital controls were imposed.
The government had to use its balance sheet to recapitalize the banks and rebuild the financial system. This meant that public debt became very high. Therefore, public finances needed to be restored. During the past couple of years, the government has taken a number of fiscal measures that have put the country’s finances back on a sustainable path.

Finally, restructuring the banking system was obviously a huge challenge. The size of the banking system was equivalent to about 1,000 percent of GDP before the crisis. It now stands at 200 percent of GDP, so there has been an enormous downsizing. The core banking system has been recapitalized and is fully functioning, a significant achievement for the authorities.

In light of the financial meltdown, the ISK took a battering, and one of the key objectives of the IMF was to stabilise the currency the central banks raised interest rates to a whopping 18% and implemented currency controls:

Severe currency controls were imposed in November after the Central Bank attempted unsuccessfully for two days to peg the krona against the euro. The controls involved daily currency auctions for imports of certain necessities, but these failed to prevent the krona from weakening further. A new currency regime in early December supported by the first tranche of the IMF stand-by agreement led to the value of the krona rising by 25% in the three days to December 9th. Since then, however, the currency has retreated, losing most of these earlier gains. A law restricting all currency flows related to capital-account transactions and requiring exporters to deposit all foreign currency with domestic banks was passed in late November. The legislation will prevent foreign investors that hold more than Ikr500bn of krona-denominated assets from exporting these assets for up to two years.

Perhaps most interestingly, this is the fiscal position moving out of the crisis:

The 2009 central government budget that was presented to the Althingi (parliament) in mid-December already provides for substantial expenditure cuts on both current and capital spending, as well as an increase of 1 percentage point in personal income tax rates. These cuts will make the deepening economic recession, including an expected fall of 20% in domestic demand, even worse, but are considered necessary by the government. The deficit on the public finances in 2009 is forecast by the government to be just over 10% of GDP, which the IMF has accepted, deeming any further expenditure cuts as likely to cause possibly irreparable damage to the economy. However, the IMF will be expecting further fiscal consolidation measures in order to reduce the deficit from 2010. We expect the deficit to be slightly higher than the government's estimate, at around 11-12% of GDP, but also that any reduction achieved in 2010 will be fairly modest.

It is rather surprising, but I was unable to find much detail on the spending cuts, despite looking as some Icelandic websites (probably a poor search term?). However, I did find some detail from a rather unusual source, which is the World Socialist Website:

On June 26, a comprehensive agreement was announced between Iceland’s government, trade unions and employers’ organisations, containing plans for sharp public spending cuts and tax hikes. The “stability pact” had been under negotiation for several weeks and is in response to pressure from the International Monetary Fund (IMF) for the government to seek a balanced budget by 2013.

Speaking at the signing of the agreement, Prime Minister and Social Democrat (SDA) leader Johanna Sigurðurdóttir commented, “Now we have a map showing the route that employers and workers in both the private and public sector, together with the state and municipalities, have agreed we should follow.”

Presented as an agreement for “shared sacrifice,” it will facilitate the bail-out of the financial elite at the expense of the working class. Such an approach has been endorsed fully by the Left Greens, the junior partners in the governing coalition. Finance Minister and party leader Steingrimur J. Sigfússon insisted that, given the economic climate, “this is a hard choice but unavoidable.” [my comment; see below]

The government has given way entirely to the dictates of the IMF. In total, the government will save 70 billion kronur (€390 million) through spending cutbacks and reorganisation over the next three years, while at the same time increasing income taxes and charges on everyday items such as soft drinks to meet a budget gap of 170 billion kronur over the next four years. The planned tax hikes will account for up to 58 billion kronur.

Essentially, what we see in the case of Iceland is a tempory backstop from the IMF, combined with deep reform of the economy. The IMF originally insisted on bailing out the losses taken from Icesave, but referendums prevented this:

Yet, while the U.S. and the rest of Europe were busy with the unpopular business of propping up failed banks with taxpayer dollars, Iceland headed in the opposite direction. It guaranteed the deposits of citizens, but refused to pay off many foreign investors. And even when the government tried to pass a bill that would pave the way for the repayment of some US$8 billion worth of deposits that angry U.K. and Dutch governments had covered for their citizens, Grímsson stepped in—not once, but twice—so that the deal could be put to a referendum. He later said the decision was an effort to reaffirm the importance of democracy and civil society in Iceland. “There were a lot of people who predicted it would be the downfall of Iceland, that we would be isolated in the world and become the Cuba of the North,” he told CBC Radio in a recent interview. “But the fact of the matter is, the people of Iceland twice were able to exercise their democratic will, and now Iceland is coming out of this crisis and establishing recovery earlier and more effectively than other European countries.”

In short, the IMF loan bought time to allow a restructuring of the economy to make it more competive, and to effectively ensure that the country 'lived within its means'. Some have argued that this picture is too rosy, and I will therefore let the critic have their say:

Though Arnason agrees with the government’s general response to the crisis, he argues that many foreign observers have conveniently ignored key details when they marvel at Iceland’s “recovery.” In particular, he says a decision to prolong strict capital controls, used to stabilize the country’s plummeting currency by preventing money from leaving the country (Icelanders who move away need permission to take their financial assets with them), now threatens the country’s key industries—the same ones that are supposed to lead Iceland back to economic health. “Basically, the currency controls distort economic prices and prevent Iceland’s budding export industries from developing,” he says.

As regular readers would guess, I would not have favoured capital controls over an extended period (although could just about accept them as a brief emergency measure). The major advantage that Iceland had was that the country did not follow the bailout route, and this makes an interesting comparison with Ireland. The comparison between Ireland and Iceland has not gone without comment with this from the Irish Indendent (also see this from Reuters):

Here, we search for weaker countries with which to compare ourselves and suck up to the bureaucrats. Our leaders first picked on Iceland. We're not like Iceland, they trumpeted. We're not militant like those silly Icelanders who voted to reject a deal that would have forced them to pay the debts of reckless bankers.

Tell us what to do and we'll do it, our leaders said. We're submissive Ireland, not aggressive Iceland. To austerity and beyond!

How did that work out? Both countries took a hiding, as they were bound to in a world dominated by bankers and their political friends.

But here's another couple of numbers. End of 2010, unemployment in Ireland, 13.9 per cent. And in Iceland, 7.7 per cent.

Of course, another key difference between Iceland and Ireland is that Iceland has its own currency, and the devaluation of an overvalued currency (the country was pre-crisis a miracle economy) saw the economy become more competitive in respect to its real wealth generating industries (e.g. aluminium, fishing, tourism).

It is odd, is it not, that the necessity to bail out the banks in other countries was shouted from so many rooftops, that we were deafened with the sound of the wailing to save the banks. In light of this, perhaps the most odd discussion comes from an article I quoted from earlier:

But some question whether the response to Iceland’s collapse would work elsewhere, or whether anyone would actually want to try. Take, for example, the decision not to bail out the banks. Most agree Iceland simply didn’t have any choice. The sector’s debts, mostly in foreign currencies, were so great compared to the tiny country’s economy that guaranteeing them would have only made things worse. Iceland also benefited by not being part of the eurozone (though it now wants to join). The krona dropped like an anchor and gave export and tourism industries a boost, helping to offset some of the decimation of the financial sector.

So choosing to bail out the banks was a good idea, just because it was possible? This does not seem to be an argument at all. If Iceland had caved into bailing out the banks, we can only speculate how the economy might now look with the cost of the bailouts sitting on the government balance sheet. My own view is that the country would still be in deep troubles.

Note: The IMF lending to the country will, of itself, give an artificial boost to GDP and employment. However, the government is using the time given by the loan to transition the economy. This is very different from the rather sad example of so-called 'austerity' in the UK, where the borrowing is through bond issuance, but where the borrowing hides the underlying structural weakness of the economy. My guess is that, when coming off the IMF drip, Iceland may see a dip or period of stagnation in the economy, but I am guessing that they have made most of the adjustment necessary to reflect their real wealth generating capacity. With the UK, there has been no real adjustment yet. Perhaps it will take a dose of IMF imposed austerity to make the transition?

Note 2: Apologies for any spelling mistakes. I am not sure that the Blogger spell-checker is working, and it is sometimes difficult to spot your own (sometimes glaring) mistakes.

Note 3: I forgot to mention for newer readers; I was opposed to the bank bailouts at the time the crisis broke. Take a look through the archives, and you will find that I did not have anything good to say about them whatsoever.

Note 4: Some responses to comments on the last post...

Lemming: Yes, you are correct that some of the savings are likely to be somewhat questionable! With regards to UK debts being backed by assets such as housing (your 2nd comment), yes the argument is dubious - as the asset prices will reflect the erzats size of the economy. Let's say that the UK's real size without borrowing is 20% smaller than it appears (I calculated roughly this figure for the US economy if you remember the post, but cannot recall the number for the UK); would house prices really remain at current levels (in real terms)?

Anonymous: Thanks for the link on the necessity for Europeans to live within their means! It is a long standing theme of the blog.

Jonny: Your comment requires a much longer response, so apologies for not replying. However, good questions.....

General: As always, thanks for all of the comments, which are (as ever) well considered. Sorry I cannot respond to all, but time is limited.
 

The Crisis is Steadily Moving Towards Denouement

First of all, apologies for the lack of posts recently. I have simply not had the time to post.

Are others seeing that there is a slow and steady unwinding of the economic situation? There now appear to be signs of substantial cracks the edifice of the illusion economy. A review of the news sees several apparently unrelated stories, but nevertheless they cumulatively represent the underlying flaws in the attempts to hold back the underlying reality of the world economy.

First of all, there is the ongoing saga of Dubai, the exemplar of the worst excesses of property speculation:

Fresh fears about Dubai's ability to resolve its huge debt mountain returned to global stock markets today as shares across America, London and Europe tumbled.

In America, the leading Dow Jones industrial index fell 111.63 points to 10,278.48 at 3.40pm in New York.

Earlier today, Abdulrahman al-Saleh, Dubai's finance minister, admitted that six months may not be enough to restructure Dubai World, the state-owned conglomerate which owns Nakheel, the property developer.

It later emerged that Nakheel made first half losses of $3.65 billion, according to Bloomberg, after taking a huge writedown on the value of its land and developments. Two weeks ago, the Dubai Government asked creditors to grant Dubai World a six-month standstill on its repayments of nearly $60 billion of debt. Dubai World then announced plans to restructure $26 billion of its liabilities.

Likewise, there are the ongoing problems of Greece, perhaps an outrider for the larger Western economies. Greece presents another crack in the edifice of confidence in government debt:

The agency placed the country on credit watch negative, meaning it is likely to lose its A- rating within months. The country already has the lowest credit rating in the eurozone, but has come under greater scrutiny amid fears that its newly-elected government may avoid imposing significant cuts on the public finances

[and]

Following the recent crisis in Dubai, investors have become doubly sensitive to the risks of sovereign debt crises, with others warning that the UK is similarly exposed.

S&P also revised its outlook on Portugal’s sovereign-credit rating to “negative” from “stable”, blaming a deterioration in public finances.

As I have previously argued, if the UK falls, the US will soon follow. In the meantime, President Obama is reacting to a swathe of bad news with yet more 'stimulus' spending, at a time when the creditors to the US are already very nervous:

WASHINGTON – President Barack Obama called for a major new burst of federal spending Tuesday, aiming to jolt the wobbly economy into a stronger recovery and reduce painfully persistent double-digit unemployment.

Despite Republican criticism concerning record federal deficits, Obama said the U.S. must continue to "spend our way out of this recession" as long as so many people are out of work. More than 7 million Americans have lost their jobs since the recession began two years ago, and the jobless rate stands at 10 percent, a statistic Obama called "staggering."

Congressional approval would be required for the new spending, the amount unspecified but sure to be at least tens of billions of dollars.

This new stimulus comes on top of the news that the fiscal situation in the US is already in an absolutely appalling state:

In October and November, the government spent $292 billion more than it took in, the nonpartisan Congressional Budget Office said.

That was even worse than the same period last year, when the government was on its way to posting a record $1.4 trillion deficit for the fiscal year that ended Sept. 30.

The federal budget has been battered by the worst economic downturn since the Great Depression of the 1930s, as tax revenues have plunged and spending on safety-net programs like unemployment insurance have skyrocketed.

What we are seeing is the ongoing unwinding of the many bubbles, and that the forecasts and announcements of the end of the crisis are indeed premature (which has long been my argument). Even Bernanke is admitting that there are ongoing and deep problems, and the $US continues to decline:

The dollar resumed its slide against the yen, euro and other currencies after climbing in recent days amid hopes the US might stage a quicker-than-expected rebound.

On Monday, however, Fed Chairman Ben Bernanke said the world's largest economy was facing "formidable headwinds" — including a weak job market, cautious consumers and tight credit — that would limit the pace of recovery.

Obama expressed shock at the relentless rise in unemployment, but around the world a dire situation continues to deteriorate. This is just one example from the Times:

London traders were also unnerved by new data on industrial production, revealing flat output in October, signalling that Britain, which is still in recession, has made a weak start to the fourth quarter. The CBI also published its industrial trends survey, which showed factories expect output to fall in the coming months.

The weak data was released ahead of the Pre-Budget Report tomorrow when the Chancellor is widely expected to reduce his forecast for Britain's economic growth this year from a decline of 3.5 per cent to 4.75 per cent.

Meanwhile, European markets were unsettled by Fitch’s decision to cut Greece’s sovereign debt rating to BBB+ from A- with a negative outlook - the first time in 10 years a major ratings agency has put Greece, the eurozone's weakest economy, below an A grade. Fitch cited fiscal deterioration as the reason.

Also weighing on European stock markets was worse-than-expected German industrial production data. German industrial output fell 1.8 per cent in October, largely as a result of weaker production of machinery and cars, against expectations of 1.1 per cent growth.

As ever, the nervousness about the situation continues to be seen in the price of gold:

GOLD soared through US$1,200 (S$1,657) as investors and speculators feared renewed US dollar weakness following President Barack Obama's decision to substantially boost the war effort in Afghanistan.

Other factors that have boosted the demand are worries about quantitative easing, that is, money printing in the US and UK, punitively low interest rates for savers seeking a home, fears of renewed inflation and persistent turmoil in the Middle East.

Uncertainty in Dubai with expectations of bailouts and a general rise in oil and other commodity prices are other reasons.

There are some curiosities in the news, such as the ongoing rise in house prices in the UK. One just has to ask why house prices might be rising in a sinking economy to know that this is yet another illusion. After all, with unemployment rising, where is the money coming from? One article suggests that it is a lack of supply of houses for sale as the driver, but it is certain that the rise in prices does not reflect the real economy.

Essentially, any review of the news shows that the attempts to reflate economies with printed money and massive government borrowing are simply not working. The cash for clunkers, the massive spending on 'make work' projects are a dead end. Printing money with no economic foundation will simply not work.

The one thing that might work, the reforming of the economic structure of the troubled economies, is the one thing that is never considered. In the early days of the blog, I wrote some examples of how the UK economy might be reformed. I am not sure that the UK will be able to even afford to support the reformed economy that I proposed. It is too late. Instead of using credit to manage the transition to a more lean and competitive economy, credit has been used to try to hide the reality of the economic situation. The same might be said of other economies, such as the US.

I keep on asking how long can this continue? How long before the illusions shatter? I am amazed that it has lasted this long.

Note 1:

In an early post during the bailouts, I mentioned that all of the money given to support the UK banks was not to protect little old ladies' savings, but to support overseas creditors. This is what I had to say in a post titled 'The UK and the Silent Bank Run' (written March 2009, but I think I argued this point at the outset of the bailouts, but can not find the article):

If we think of the numbers that we are looking at, it becomes self-evident why the endless bailouts by the government are falling into a black hole. The government is having to bail out the banks to repay these overseas investors such that, as fast as the money is pumped in, it is pumped straight back out to meet the demands of overseas depositors. With the banks sitting on mountains of toxic debt, with no market left for the sales of these toxic assets, there is nowhere to turn except to the government.

It is as I have long suspected. I have always been of the view that this is not really just about bailing out little old ladies with their savings held by RBS, but also about bailing out all of the overseas investors who stand to lose so much money.

This is an article in the Telegraph:

British taxpayers stand behind more than £167bn of toxic assets in the US, Ireland, the Middle East and beyond, it has emerged as the Treasury disclosed details of what Royal Bank of Scotland has dumped in the state insurance scheme for bad debts.

Most of the £281.9bn of assets RBS has placed under taxpayer protection are based outside the UK, with loans secured against everything from negative equity properties in Dublin to hedge fund assets in Caribbean tax havens and container ships docked in ports around the world.

I suspect that this is just the tip of a very large iceberg, and the same will be found for the US. What we have witnessed is the salvation of the banks to protect overseas creditors. These were the same creditors who flooded the economies of countries like the UK and US with money, which in turn created the asset price bubbles and credit bubbles. In the case of the banking industry, it is heads I win, tails I win. It was never about protecting the small domestic depositors, but bailing out overseas investors.

Note 2:

A slightly rushed article as I am still pressed for time. However, I hope it provides some evidence that we are a long way from any real or sustainable recovery.

Bleeding the 'Real' Economy to Support the Financial System

I am in the highly unusual position of agreeing with Krugman (or at least in part), the Nobel winning economist who writes in the New York Times. He has just recently written an op-ed on the subject of the huge profits being achieved by Goldman Sachs ($US 3.4 billion), and says the following:

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you’re a banker, and you generate big short-term profits, you get lavishly rewarded — and you don’t have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don’t understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong.

Inevitably, the massive bonuses that Goldman are about to distribute are a major point of the controversy. However, whilst this is all good populist material, the focus should be on a system in which the banks were bailed out in the first place. As Krugman identifies, it is a case of 'heads they win, tails other people lose'. Krugman, I recall, was in favour of 'saving' the financial system, as were many others. What we are now seeing is the result of the 'salvation' of the system. The banks that took huge bad bets are now appearing to make large profits.

Regarding Goldman Sachs as the evil in the machine, the populist mantra of the day, I will not criticise them. Provided that they act in the law, their duty is to do the best possible for their shareholders, and also their employees. Goldman Sachs are simply doing a very effective job within a framework that allows them so much leeway. They are no different from GM in holding out their hand for government support, but are simply more effective at doing so. Goldman Sachs are just a symptom, and are certainly not the cause of the problem. It is not their role that should be subject to criticism, but the government and the Federal Reserve - it is the state that is the problem. It is the state that is at the root of the appearance of the bumper profits and bonuses at Goldman Sachs.

I say 'appearing', as there are real question marks over how 'real' these profits actually are. The bailout of AIG has been linked to an indirect bailout of Goldman Sachs, for example by the bane of Goldman Matt Taibbi of Rolling Stone magazine. On top of AIG, it is not clear how much Goldman has been bailed out by the various programs that have been enacted to remove toxic assets from the balance sheets of banks, as the recipients of such bailouts is shrouded in secrecy. There are also the changes in accounting rules have allowed banks to do some extraordinary accounting tricks:

During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, have plunged to fractions of their original prices. That has forced banks to report hundreds of billions of dollars in losses over the last year, because some of those securities must be reported at market value each three months, with the bank showing a profit or loss based on the change.

Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market. At first FASB, pronounced FAS-bee, resisted making changes, but that changed within a few days of a Congressional hearing at which legislators from both parties demanded the board act.

This is just one example. In other words, as a result of the bailouts and the changes to the accounting rules, it is nigh on impossible to work out exactly where any real profits might lie. Quite simply, nobody but the banks themselves and the Federal Reserve, and perhaps other arms of the government, can untangle the real state of the banking system. However, it is almost certain that the sudden profitability of the banks is rooted in the various bailouts and accounting tricks. Whilst it is quite plausible that many parts of the Goldman operations are profitable, the overall genuine profitability is buried in the accounting and the bailouts. Krugman identifies the complete opacity of the situation as follows:

I won’t try to parse the competing claims about how much direct benefit Goldman received from recent financial bailouts, especially the government’s assumption of A.I.G.’s liabilities. What’s clear is that Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.

Under such conditions, it is no wonder that so many commentators are calling 'foul' over the massive bonuses that are going to be paid out by Goldman Sachs to their employees. However, the underlying problem remains as to why all of this has taken place. Why have the changes to the accounting rules taken place, and why are toxic assets being taken off the hands of the banks, thereby transferring risk from the private sector to the state sector?

The argument has been that certain financial institutions are 'too big to fail', but the reality is that the various government measures to support the situation is entrenching the system in which the large financial institutions threaten the financial system. With each bailout, with each measure, they undermine the market forces which might discipline the banks, creating ever more public exposure to private risk taking. In doing so, they simply embolden the banks to take further risks.

As was identified at the start of the process of the bailouts, there is an inherent moral hazard in bailing out banks, in that they cannot lose. They become a one way bet, and that will, however much oversight is applied, eventually lead to complacency, and excessive risk taking. It is now apparent that, under the current system, profit is guaranteed by public institutions. The worst case scenario for the major banks is that they might have a few quarters of poor or no profits, but there is an implicit guarantee that the government will do whatever is necessary to engineer a return to profitability. There will be no more Lehmans in the future, as the new regulatory regime will never allow another major bank failure for fear of a repeat of this crisis. One way or another, the 'too big to fail' banks will be immune from any major losses.

The solution given by many, like Krugman, is more supervision and regulation. However, if a bank is 'too big to fail', with proposals for special levels of supervision as a result, it will become to be seen as the 'safest' kind of bank. If a bank is seen as 'safe', it will offset any measures such as stronger capital adequacy requirements through being able to raise finance more cheaply, and through the state guarantee will win more business, and the result will be to just get bigger, and consolidate ever more risk into a small number of institutions. The crisis has already seen a consolidation in the number of major banks, and this process is likely to continue.

The problem is that the same regulators who failed to see the risks in the current system will be responsible for regulation under any new system. Whilst they might (possibly) be able to spot the kind of risks that caused the current financial meltdown, what is to say that they will be able to spot the risks that arise in the next particular set of economic circumstances? The difference is that, next time around, it is more likely that there will be even more concentration of risk in a few major institutions, and therefore even greater system-wide risk.

If you doubt what I am saying, take a look at one of the key policy makers discussing the state of housing and the financial system pre-crisis. I found this video of pre-crisis statements by Bernanke on Reddit recently. For the many out there calling for more regulation, you will need to think about how the regulators might be able to identify risk, when the record of policymakers is so abysmal. Quite simply, the policymakers who will formulate the regulation are clowns dressed up in important titles, armed with mechanistic formulae and jargon.

Whilst all of the shenanigans continue in the financial sector, the 'real' economy in the US continues to bleed. At some point in time, it is the real economy that will have to pay the price of the salvation of the 'financial system'. Again, I find myself agreeing with Krugman:

The bottom line is that Goldman’s blowout quarter is good news for Goldman and the people who work there. It’s good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it’s bad news for almost everyone else.

The fact is that, one way or another, the 'real' economy will eventually be paying for the profits at Goldman and the massive bonuses, and that 'real' economy is already suffering extreme pain. In the meantime, it is not apparent that the 'salvation' of the financial system has translated into salvation of the economy. For all the talk of 'green shoots', the US economy continues on a steady descent, with all the pain that means for those working in the 'real' economy.

The panic engendered when the financial crisis hit is now over. I argued against the bailouts at the time that they were taking place, at that moment of panic. I argued that the resource being poured into the banks would be needed whilst the economy restructured. I argued that the bailouts would continue on from those that were proposed at the start, and that is what has taken place. And.....every single $US that has been poured into the rescue of the financial system will one day be repaid in taxation from the 'real' economy. I argued against the bailouts on this principle.

All of this, hidden in opacity, has led to a point at which insolvent banks are now able to make a 'profit'. Exactly why has this massive bleeding of resources into insolvent banks been allowed to take place? Where exactly is the salvation of the real economy, the pot of gold at the end of the rainbow of the financial system? Like the pot of gold and the rainbow, if we just go a bit further.....we might just find the pot of gold.

In this terrible mess, the point that is forgotten is what a financial system is actually really for. It only exists to allocate accumulated capital and provision of insurances; the financial system should be a support to the real economy, by efficiently allocating capital. It is entirely unclear how pouring trillions of dollars into insolvent institutions, capital which will eventually be taken out of the 'real' economy, might facilitate this. The 'real' economy is now expensively supporting the financial system, rather than the financial system supporting the real economy. It seems that this is the exact opposite of what a financial system actually should be doing. It is simply beyond any reasonable explanation.

It is the same policymakers who are supporting the financial system at the cost of the economy who will be formulating the new regulatory framework. It is the same policymakers who failed to see the risks inherent in the financial system that will be overseeing and regulating the future risks in the financial system. It is the same policymakers who have overseen the consolidation of the banking system into fewer hands, who are engineering a system in which banks will be ever more concentrated. It is the same clowns who were responsible for the current mess in the financial system, who have engineered that insolvent institutions make profits, that will suddenly have the wisdom to create a 'safe' financial system in which major risk is banished.

It is not an encouraging prospect.

Note: The use of the term 'real' economy is a convenience, as the financial system is actually part of the real economy. As such it is used simply as a way of saying that I am referring to the provision and exchange of services and goods outside of the financial sector.

Bank Nationalisation - A Continuation of the Debt Economy Delusions

The dust is starting to settle on the first tranche of bank nationalisations, so I thought it might be worth considering what this will mean. First of all a quote from the Telegraph article (link above).

'Mr Brown was said to be "genuinely shocked" when he was told how much cash was needed to recapitalise RBS, which was ordered to accept up to £20 billion of investment, making the Government the majority shareholder.'

This is an interesting point, as it is an indication of how severe the problems are. However, my suspicion is that this is about the problems at this current stage of the crisis, not the problems that are going to emerge as the economy continues to contract. There is already talk of needing more money for the bailouts and, as more and more consumer credit, commercial debt and mortgage debt goes bad, there will be ever more need for additional financing. In other words, this is only the start.

The next quote from the same article is also very revealing:

'Banks will effectively be state-run, with Government-appointed board members put in place to ensure it once again begins lending to businesses and individual customers. Together with Northern Rock and Bradford & Bingley, the move will mean the Government effectively has four of the country's biggest lenders under its control.'

This really goes to the heart of the matter, as it is here that one of the greatest dangers lies. The question here is 'lend to whom, under what circumstances?' Aside from the long term risk of political decisions on lending (using the banks money to lend to failing 'key' industries etc.), there are more fundamental questions.

It is not entirely clear from anything that has been announced exactly what the direction of this lending might be. As such, I need to speculate on some examples. Let's start with lending into the individual consumer mortgage market. If this is the direction, then the lending will be directed at a market where the security for the loan is declining in value. In this situation, unless there is a considerable deposit required, the banks will be lending into a very high risk market. If it is consumer credit, then it is an attempt to prop up the service sector, and in doing so prolong the credit driven economy. Furthermore, if this is the intention, it is again lending into an increasingly risky market, as unemployment is now increasing very quickly, and that will mean ever more consumer debt defaults. If the lending is to businesses, once again, the risks are very significant, as the economy is entering into recession and that means an increase in commercial failures. Finally, if it aimed at inter-bank lending, it should not be forgotten that the reason for banks lending to one another is because the banks are worried that other banks are insolvent. The scale of these problems have already been revealed in the nationalisations.

Now the key question. Will this new lending be used in any significant way to build new productive assets, such as new manufacturing plants, or investment in new technologies and equipment for manufacturers? In other words, will the money be lent into wealth creation investments, or will it be used as a continuation of the debt money-go-round? Why is it that I suspect that very small percentages will be used for real wealth creation?

In short, banks are not lending not only because of hoarding of capital, but also due to the fact that there are very high risks in most forms of lending at this time. In other words, the government will be forcing the banks into behaviour which will, in the long term, just create more problems. I may be wrong about the lending into real wealth creation, but I do not think that this will be the case. The underlying idea in these nationalisations is to restore 'confidence', and by confidence the government really means to prop up the service based economy with new lines of credit.

The government is talking about re-privatisation in about five years time, and suggesting that the nationalisations will not cost the taxpayer money in the long term. The idea that the government will be able to gain any return on the investment, in light of what I have discussed, is very remote indeed. Instead, as the finance of the nationalised banks continue to decline in parallel with the economy, the government will find itself having to provide more and more capital injections to keep the banks afloat. This will be never ending, as the risky lending that is the condition of the nationalisation will just produce ever more toxic debt.

As if this were not bad enough, these nationalisations are creating a massive distortion in the banking market. In a recent article, Barclays (not one of the nationalised banks) has suggested that the nationalised banks will be hobbled by state intervention. This could not be more wrong. There is a precedent for what happens when there is an implicit state guarantee for a financial institution, and that is the example of Fannie Mae and Freddie Mac. The result of the implicit state guarantee meant that these institutions could raise money more cheaply than rivals, leading to their domination of the US mortgage market. This in turn left only high risk lending markets, untouched by the two mortgage giants (except that they bought into the risk through the 'backdoor'), for their rivals and is one of the explanations for the growth in sub-prime. In the case of bank nationalisation, the guarantee is not just implicit, but is explicit. What kind of distortions will emerge from this?

If both individuals and companies see the nationalised banks as a safer bet, it may well be that there will be a shift in deposits to these institutions, creating a chain reaction of crisis in institution that might otherwise have been healthy. It is possible to speculate that the Barclays spin on the crisis is designed to forestall such a reaction.

All of this is to leave aside the sorry history of nationalisations in general. I need not detail the long history of how nationalised industries end up as bloated corporate welfare institutions. Whilst there have been a smattering of successes, the majority of nationalised industries turn into long term drains on government finances. With the appalling state of the nationalised banks, combined with government use of the nationalised banks to achieve broader national economic aims, what chance do these banks have of ever achieving commercial success?

The most worrying aspect of this is that the idea is now spreading around the Western world. Euro zone countries and possibly the US (in a modified form?) are using the UK solution as a template for their own 'rescues' of the financial system. The idea that the rest of the Western world is following a solution like this is very disturbing. Yet again, it is a continuation of the delusions that have been driving the economic policies of the governments in the Western world. Yet again, more debt, more borrowing from the rest of the world, is seen as a solution. The idea that this is anything more than an attempt to reflate the debt based economy is the great delusion. However, the governments will point to the rise in stock markets as evidence of the success of their plans. Such a positive swing in sentiment will only be a pause, as economic reality will once again intrude on such misplaced optimism.

For regular readers, my analysis of this situation may come as no surprise. It is just a continuation of my argument is that the only real solution to the current crisis is long term structural reform that promotes real wealth creation for the economy. However, I have analysed the current crisis from a different perspective, which faces the reality of the changes that have taken place in the world economy, and this is why my analysis differs. Furthermore, I have posted many times suggesting that the US and UK economies are actually structurally bankrupt. These nationalisations have seen the government of the UK take on ever more liabilities, and this will stretch an already dangerous financial position ever faster towards the breaking point.

Perhaps the most shocking part of all of this is that the nationalisations seem to have very broad based support. The only explanation for this is an ongoing desire to stick our heads in the sand, and hope that the underlying economic problems will just to away. As I put in the title, just a continuation of the ongoing delusions.....

Note 1: I have had a comment from 'LordSidcup' (name from the Jeeves novels, I believe) asking a question as follows:

What better alternatives can YOU suggest that Gordon Brown should do in the short to medium term

My answer to this is simple. There is no short term solution. I once made a comparison with governments and King Canute trying to turn back the tides (Canute knew he could not actually do this). If I might stretch the analogy a little, this is like trying to build a wall of sand on the beach to turn back the tide. Just as King Canute knew that the tide could not be turned back, so do I. This is not 'defeatism' but recognition of the reality. Some number of posts ago, I made the comparison with a household on the threshold of bankruptcy, and how tempting it was to put off finally facing the reality with a last big loan. It is not changing the real problems that they have to face, that they do not make enough money to cover their debts and expenditure, and that they really just need to accept their real financial position. The new loan will just prolong the pain that bit longer, and leave them with ever greater problems.

I have proposed some solutions which will take a few years to really impact the system in any significant way, some of which can be found in the links at the top of the page. For the short term, there are some fast 'hits' that can be made, which may be able to help government finances. A long time ago, I started reviewing the comprehensive spending review, but only managed 1 of the 2 posts before events distracted me. One of the purposes was to look at where tax money actually goes, and to identify the most obvious areas of waste to be culled. However, in light of my not having done this, I can only suggest a look through the 'Taxpayers Alliance' website, which looks closely at waste. However, I must emphasise that these savings will do nothing to 'save' the economy in the short term, but are a good start for hastening recovery in the medium term.

The simple answer is that, one way or another, there is nothing that can turn back the tide, and governments should be concentrating on how they will manage a recovery and a return to the business of real wealth creation. I note that there was accusatory 'YOU' in the post, suggesting that it is easy to sit on the sidelines and criticise. I hope that, if you read my solutions, you will see that it is not for the lack of imagination that I offer no solution. I am not offering any soltuions because of an acceptance of the reality of the situation. The reality is -

Wealth is made - not borrowed money or something imagined into existence.

Keep this in mind, and the walls of sand being built on the beaches will be seen for what they are.

US Government Guarantees a Crash

Update: 23 Sept. Just a note. It seems that the bailout will be financed through borrowing, which is a relief. Better that than just printing money. However, not bailing out the system is the best option, but at least this is better than the worst case.........

I have had a comment in which one of the regular commentators (Lemming) on the blog has played devil's advocate, and put forward an argument that the bailout is the right thing to do. This is the argument put forward:

'Aside from external debt, does a country's internal debt matter, anyway? If most of the bad debts which are being monetized were as a result of over-inflated house prices it won't matter if they vanish into thin air, will it? It's just good for some people, and bad for others, with a net result of zero. (People spent money on imports with the dollars they raised against their houses, however, but more fool the foreigners who were taken in and who exchanged real goods for worthless paper.)

Is the same true for derivatives 'de-leveraging'? That is, if the debts and 'assets' had never existed nothing material would change?

At the end of the day, if the world's economy was 'reset', we would still have the same level of prosperity we have today, wouldn't we? There would still be the same natural resources, the same number of people with the same talents, and the same infrastructure. The financial system has got itself gummed up, and technically some people have enjoyed a standard of living they did not deserve, (financed by others who were seemingly happy to pay for it) but if the whole world can see that by insisting on following through on every failed loan and transaction, that it drags everybody down into the mud, it might be best to 'start again' and reset the mechanism. Sure, some people in far away lands are owed some money for past productive activity, but even they might see that they must 'let go'?

Is this the logic that has led to the US dollar being artificially propped up by the world for years, i.e. that it is better to keep the mechanism running, even if it results in undeserving people living in luxury, than for the mechanism to grind to a halt. Have we reached the stage where it is impossible to keep the mechanism running whatever we do, so more drastic action is needed?'

The first point to make is that it is now apparent that the 'rescue' of the financial system will be financed through monetisation ('printing' money), not through government borrowing . This approach will have very serious consequences for the US and world economy.

The first problem this presents is that it will destroy confidence. I have discussed the importance of confidence in a fractional reserve banking system elsewehere in the blog. The important aspect of the post is that in a system of fractional reserve banking is that money in such a system has no value whatsoever except what we collectively believe it has. By printing money in this way, the US will certainly destroy confidence, as there appears to be no limit on what the government is willing to print.

The result of this unconstrained printing of money is that the $US will fall. This is very different magnitude of fall compared to that which would occur has the US government decided to finance the bailout through borrowing. In the latter, the bailout would be funded by the US taxpayers, but in the former the pain is shared around the world by all holders of $US assetts. This may appear to be a clever move, as it shifts the burden more widely, and moves some of the pain to the rest of the world. However, the price will be high for printing money (see article here for an example - though the article does not give a picture of the seriousness) .

As I have already mentioned the entire banking system rests on confidence, and this is a fragile base for a financial system. If you destroy confidence, money has no real value whatsoever, and this is the problem of removing a currency from exchange for a tangible asset such as gold. If you give me $1, I will only value it if I believe that the next morning I can still use it to buy the same amount of product as I could today. If I no longer believe in this, and it is just a matter of belief, then I will not accept the $1 that you give me and will want to be paid in some other way. If a government can print money with no constraint, and with nothing to back it, then I will cease to 'believe' in the value of money. The best way to understand this is to take a look at my original post, where I make a comparison between the virtual world of 'Second Life' and the real world. When you see this comparison, I hope that all becomes clear.

This is a very roundabout way of coming to the subject of the foolish foreigners who have exchanged goods for worthless paper. Yes, this is quite right, they have done this. Yes, they have been foolish to do so. However, the system is built on trust (confidence), and those foolish foreigners will learn their lesson. That is, they will no longer trust that they will ever be paid for what they provide, or at least they will lose belief that they will ever be paid in full. This means that the TVs, the toys and all of the other imports that the Western consumer has been able to buy will only be available with a massive risk premium attached to their price, as they will have no confidence that the $US they get in return for their product will be worth the same tomorrow as it is today. I talk about this as if individual firms will take this approach, but in reality it is the collective loss of belief that matters.

What of the idea that if everything is reset, we still have the same amount of resource, the same people and the same infrastructure. This is very true, that nothing has changed 'on the ground', except for confidence. It is here that we return to the massive accumulation of debt in the Western economies. In a situation of loss of confidence, who will keep the lending going? Who will lend into currencies that are devaluing, and at what risk premium?

The trouble is that when the debt ATM is shut down, how much is all of the talent, infrastructure and so forth really able to produce? Can it produce enough wealth for Western consumers to buy the latest shiny plasma TV from a Japaense company manufacturing in China? In other words, are the Western economies producing enough to have sufficient product/services to exchange for the shiny plasma TV? The answer is that most of the Western economies have not been producing enough for a very long time, and that the continued lending was built upon a false belief that they were. Once again we come back to the idea of confidence and belief. I return here to my analogy of the aristocrat who lives beyond his income, with all of his creditors lending on the basis that the aristocrat's family always having been so wealthy for so long that they just can not believe that in reality he is broke.

The reality is that the majority of the Western economies are just not producing enough value to continue to live in the manner to which they have become accustomed. We are, in reality, broke and in debt. No one is going to lend to us, and we now have to adapt to living on the value that we really produce.

Yes, the world has kept the West living in luxury, but it has been no conspiracy. It is, as I have said earlier, that the world has just 'believed' that the West was rich, and always would be. The world is waking up to the reality, that when they lend to the Western economies, that the Western are unable to produce sufficient goods and services to pay back what has been lent or, put another way, the West is unable to produce sufficient goods or services of sufficient value to make trading with them on todays' terms worthwhile. That means that the terms of trading with the Western economies will be more realistic, and that means the value of currencies must fall - and fall by a huge amount. There is no possibility of resetting the mechanism, because the mechanism was never a deliberate policy, but was built upon a collective delusion.

What can be done? What drastic action can fix the problem?

The answer is that nothing can be 'done'. Printing money will only exacerbate the problem, fuelling hyper inflation. For the Western economies, such as the UK and US, they will simply have to adapt to living within their means. The welfare states, the health services, the wasteful use of money by government will all be unsupportable. The massive boom in services, the expensive restaurants, the crystal healers, the retail expansion - all of these will shrink back to a sustainable size to reflect the contraction of the economy as the debt ATM shuts down. The result will be massive unemployment, unemployment on a scale that we have never imagined. The foreign investment will dry up completely, the cost of all the imports will surge, as well as the cost of commodities.

I have previously suggested that inflation would be held back by the rise in unemployment, that costs in the UK would be held down and that this would counter the worse effects of devaluation. I no longer believe that will be the case, as I now believe that the currency collapse will be so severe that massive inflation is the only outcome. I wrote a couple of months ago that it was hard to believe the logic, the inevitability, and the severity of what is coming. I suggested that I had been too conservative in my predictions, that it would be worse even than I had suggested in 'A Funny View of Wealth'. Now, as we stare over the precipice, the distance to the bottom is becoming ever more clear, and it is a very scary thing.

As I sit in my comfortable home, enjoying the comforts of the Western lifestyle, it is hard to imagine that it is coming to an end, but it is. In my case I am hoping that I have taken a course of action that will insulate me from the worst of what is to come (at least for three years), but I worry for those who will be exposed to the full force of this economic hurricane, and wonder how the world will look in two years time.

I suspect that it will not be a pleasant sight.

Note 1: Lemming also posted a link to a very interesting site. I strongly recommend it to all the readers here. It includes articles by Ron Paul, and for readers of this blog in the US I would strongly recommend Ron Paul to you. He appears to be the one potential leader who understands the situation, and knows what to do. Quite simply, you should be begging him to run for president, though sadly it is probably too late. In the UK I see no such potential leaders, and that is a very worrying thing.

Note 2: I have just taken a look at the Sunday editions and found the following:

'After a week of unprecedented financial turmoil, they predict that government borrowing is about to surge as the Treasury’s tax take is slashed by a slump in earnings from the City and the downturn.

Leading forecasters say the government will soon be forced to borrow as much as £100 billion a year, giving Britain easily the biggest budget deficit of any western country'

This is exactly as I have been predicting, though I still believe that this is conservative. It is time for structural reform. The UK can not afford to go on as it is. If you are new to this blog, take a look at the links at the top of the blog, where I outline some solutions. If you like them, recommend the blog to others, as the purpose of this blog is to try to make a small contribution to the realisation that reform is the only way through this. If we do not accept this king of reform, the alternative will be more government 'solutions' and it is the solutions of the government that led us to this crisis.

Yet another note: I have just taken time to look at the Sunday edition of the Telegraph and the coverage of the crisis is becoming ever more gloomy. A good example can be found here (I use the word 'good' very loosely):

'Power has tangibly shifted - away from the United States and the Western world generally, and towards the fast-growing giants of the East. That's been happening for some years now'

The article in question goes on to say:

'How much more can the US taxpayer take? It sounds insane, but the liabilities being taken on by the Fed and the US Treasury are now so enormous that the government itself could default. No?'

and

'But the ultimate financial question - until recently, unthinkable - is now being asked. Yes siree, the mighty US government could default. That's how much the world has changed.'

At the moment it is the US that is take the brunt of the pounding. However, the UK economy is far, far weaker than the US economy. I do not mean in terms of what has been taken in the past to be strength and weakness (see 'A Funny View of Wealth'), but underlying strength. We are more indebted, and lack any clear competitive advantage in most sectors. If we look at the pain of the US now, we need to multiply that pain for the UK.

In another article, it appears that the FSA is trying to find a buyer of B&B. The death roll of several UK banks is starting, but expect an acceleration of the pace, as everyone now examines the state of even the most 'sound' and largest banks.

It seems that we are now entering the final stages of the beginning. In this case, the beginning is the destruction of the economy of the UK. This is the shock of the crash. I am not sure how longer this phase will last, as there may be some more false dawns, but suspect that it will just be one or two months at the most. The time scales are very much in line with myprevious predictions on this blog. As I have repeatedly stressed over the last few months, make sure that you have your liquid assets ready to move at short notice. Ensure your accounts have Internet access and, at the first sign of rumour, move your money to another account. Be careful of using the same bank but with different brands.

After the crash will be the shock. The shock is when we contemplate the financial ruins, and see the bankruptcies multiply accross all of the economy, and unemployment sky-rocket. The outstanding questions will be the final order of the collapse. Will it be national debt default, or banking collapse, or both in conjunction. Both will happen, so it is not clear that one order of disaster is better than the other. It is only to be hoped that it all happens sooner than later, as the longer the delay, the more foolish action will be taken to avert the crisis from government.

I think I mentioned in a recent post that I am shocked at the panic. As I said, I thought others would watch dispassionately as all this occured. On reflection, I can see that it is only that this is no surprise that allows me to see it as an inevitable unfolding of events. I watch as the panic unfolds, and can imagine the late night meetings in the government as they desparately seek a solution that is not there. The momentum is now going to carry the crisis forwards, whatever they do. Instead of panicked meetings, I can only hope that someone is thinking through the aftermath, and asking how to pick up the pieces. I have always had this in mind as I have written this blog.

This is my last note today, as it is all rather depressing to think about.

(all notes written on day of original post)

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?