2009 Budget Madness....

I have a curious streak of optimism that somehow the economic policy insanity will be ended. At some point, I keep thinking, the politicians will 'get it', then knuckle down and face the reality of of the task that confronts them. In my foolish optimism I held out some hope that the budget might see some kind of return to sanity. Instead, what we have is a work of complete fantasy, and a work that will plunge the UK ever deeper into an economic hole.

The part that is most shocking about the budget is the fantasy projections for the future of the economy, and many commentators have already seized upon this. For example, Liam Halligan of the Telegraph has the following to say:

One reason is that Darling’s has made some extremely rosy assumptions about future UK growth. While he admitted our economy will contract by 3.5pc this year, the Chancellor foresees a return to growth of 1.25pc in 2010, with the economy booming once more soon after, expanding by 3.25pc in 2011.

These estimates are pie-in-the-sky. Most economists think the UK will contract next year too. And I know not a single forecaster outside the Treasury betting on growth above 3pc the year after.

Even the optimist in chief amongst the economics columnists, Anatole Kaletsky, had the following to say:

Just as the Treasury, along with the IMF and the OECD and all the other supposedly expert institutions, have revised their forecasts out of all recognition in the space of just four or five months, the numbers published in yesterday’s Budget will be overtaken by events in the next few months.

Quite simply, nobody in their right mind will see the Darling figures for growth in the UK economy as anything but fantasy. The reality at the moment is that the UK has a long way to go before it reaches bottom. We have only gone through the initial stages of the economic crisis, and there is much more bad news to come.

For example, there is the forthcoming meltdown in commercial property, which will send the banking system into a new tailspin. This from the Telegraph this April:

Meanwhile restructuring experts have warned that the quarterly rent bill could be the tipping point that would force a significant number of retailers into administration. Malcolm Cohen, a partner at BDO Stoy Hayward said: "Retailers are already struggling for survival and have been further impacted by consumers reining in on their discretionary spending

This is just the retail sector, but there is likely to be a similar continuing decline in the broader commercial property market as the economy contracts. The bottom line here is that, with consumer spending contracting, the retail sectors absolutely must continue to contract. Meanwhile, despite some optimism in the residential housing market, the trend is still predicted to be downwards for a long time yet.

Another element in the ongoing banking crisis will be continually climbing numbers of defaults on consumer debt and mortgages. Even whilst consumers are paying back debt, due to concerns about the state of the economy and unemployment rising at 2000 people per day, there must be ongoing losses at all the major financial institutions, though figures for this are very hard to come by. A good indication of the problems are the ongoing problems being confronted by building societies, exemplified by the dire state of Dunfermline Building Society (which also made significant losses on commercial property). Meanwhile, consumer confidence remains very low indeed.....

Added to this gloomy picture, there is the massive decline in manufacturing output. The Times had this to say:

Manufacturing output tumbled in the past quarter, with 53 per cent more companies cutting their output than increasing - the lowest level since 1975.

Exports, which have performed more strongly in recent months as the pound has weakened, declined more rapidly in the last quarter than businesses had hoped, with a balance of -39 per cent which is far below the expected -27 per cent and the weakest figure since October 1998.

Companies expect export orders to fall again next quarter, but at a more moderate pace.

The same report also highlighted a continued trend of laying off workers. Inevitably, UK GDP is falling at an astounding pace:

Economists were expecting GDP to have contracted by 1.5pc in the final quarter of last year – in line with the preliminary estimate – but the Office of National Statistics had to revise the figure downwards to 1.6pc.

It is the biggest quarterly fall in GDP since 1980 and the biggest annual fall since the last recession in 1991.

The contraction was aggravated by a sharp revision of the fall in construction output from 1.1pc to 4.9pc in the last quarter, falling consumer spend and businesses cutting back their inventories.

It should be remembered in considering GDP that it measures activity, not actual creation of wealth. As such, large percentages of the activity will be funded through government borrowing, meaning that activity now will have to be paid for by a decline in activity at some future point in time.

Under these circumstances, with just about every sector of the economy reporting bad news, the idea that a genuine recovery will start next year is just pure fantasy. Even the IMF forecast for the UK stands as a sharp contradiction of Darling's forecast, with a 0.4% contraction next year. Within this context, the borrowing forecast being offered by Alastair Darling is pure fantasy, but is nevertheless still alarming. With an ongoing contraction of the economy, the need for greater than forecast borrowing is a foregone conclusion. As the forecast stands, borrowing is predicted to rise as follows:

According to projections in the Budget, public sector net debt, the accumulated stock of outstanding Government borrowing, will reach £1,370 billion in 2013/14.

It should be remembered that, in addition to this, there are many liabilities that are buried. For example, Private Finance Initiatives are not included, but significantly adds to the government's real level of debt. Added to this are the unfunded pension liabilities for the public sector which are believed to be double the official estimate at £1 trillion +, and the underlying problem that the first of the baby boomer generation are now retiring. This will mean less workers are going to be available to fund government activity, whilst healthcare and pension costs are set to soar:

Such high national debt is not without consequences: it leads to more expensive interest payments while the flood of new British gilts into the bond market will crowd out investment that might otherwise have gone into the private sector. Meanwhile, Britain's ageing population heralds a mass of new pension contributions, further obligations to public funds that the government probably does not want to think about right now.

Under such circumstances it is no wonder that many commentators are now questioning whether the government will be able to continue to fund such extravagant borrowing. For example, and article in the Wall Street Journal is pointing out the significant risks in the UK fiscal position, with concerns about quantitative easing (printing money) and the massive expansion in debt:

But a big expansion in quantitative easing -- already huge at 5% of GDP -- carries risks. It stores up trouble for the future, increasing bank sector reserves that will eventually need to be mopped up before they trigger an inflationary surge while adding to the BOE's stock of gilts that will one day need to be sold.

More importantly, it would fuel suspicions the BOE is simply monetizing the government's debt, further undermining the U.K.'s credibility -- and potentially precipitating the BOE's nightmare scenario.

That leaves the BOE in an invidious position. Its own credibility is all that stands between the U.K. and a full-blown financial crisis. Yet thanks to the government's refusal to spell out a credible plan to reduce government borrowing, the BOE finds itself at the mercy of foreign investors, who by the end of last year held 35% of gilts.

It wouldn't take much -- a further collapse in the public finances, another bank bailout or signs of a surge in inflation -- to undermine sterling and prompt the showdown the BOE fears.

The government could yet be forced to deliver a proper budget before the year is out.

The possibilities of a gilt strike, a refusal of markets to continue funding UK government debt is becoming an ever greater possibility. The risk of sovereign rating downgrade is looming, and there have been ongoing problems at gilt auctions - even before the budget:

The scale of the Treasury's borrowing plans -- and continued fears about the UK's ability to recover from the slump and repay its debts -- have raised the prospect that investors may simply refuse to buy all the bonds the Government issues.

The Treasury was last month hit by an "uncovered auction" when investors refused to buy all the gilts ministers wanted to sell.

Also, even before the budget, the £GB has been under pressure, and this can only serve to raise anxiety about the massive issuance of gilts:

There is evidence to support the view that sterling may have moved to a permanently lower level, reflecting a preference shift away from what the UK does best, namely financial services. But the results suggest that around 60pc, of sterling's decline since mid-2007 can be accounted for by a rise in the risk premium associated with holding sterling.

In plain English, overseas investors fear that the UK may no longer be capable of delivering the stability that it was once thought to have enshrined. And given the extent of the government's borrowing, they see a significant risk of inflation ahead. And who can blame them, sterling has form.

From the FT, we have the following:

On Wednesday, for example, the cost of protecting five-year gilts was 95 basis points – meaning it costs £95,000 a year to insure £10m of bonds – up from 18 basis points last summer (albeit down from a peak earlier this year).

But if that is embarrassing enough, the cost of insuring the chocolate giant Cadbury was on Wednesday far lower, around 50bp. A company that peddles chocolate coins, in other words, is currently deemed a better credit bet than the British Treasury itself.

Perhaps the most worrying aspect in all of this is that the markets are still paying attention to GDP as if it were a meaningful figure. As such, they measure the state of the government's debt and the ability to repay are based upon GDP figures. As I have often emphasised in this blog, GDP figures are a fantasy, as they measure activity which includes activity resultant from increase in debt. As such, with the government borrowing soaring, and massively indebted consumers and businesses, current and past GDP figures have been massively inflated by activity resultant from debt. As such, all of the analysts (I assume) are measuring the ratio of debt against a measure which massively inflates the perception of the UK's ability to repay the debt.

I have not covered the details of the budget and have emphasised the big picture of the overall fiscal position. I will not go into the details of the budget, which are quite simply tragi-comedic. However, as an example, I have already pointed out the absurdity of the car scrappage scheme in a previous post. To this we can add the 'green' measures, such as a massive investment in useless wind farms (I have detailed why they are useless in a previous post). As Britain falls ever deeper into a black hole, precious resource is being diverted into schemes which simply can not be afforded. Or there are supposedly going to be measures to trim areas of public spending, about the IFS has the following to say:

“The Government has announced that nearly £6bn of extra efficiency savings will be delivered by the public sector in 2010–11. A large proportion of these savings will be delivered by just two departments: Health and Children, Schools and Families, who have announced new efficiency savings of £2.3bn and £0.7bn respectively – equivalent to 2.2% and 1.3% of their current budgets. As a proportion of their current budgets the biggest savings come from Transport at 3.0% and the Home Office at 2.9%. Local Government and Defence have also identified large efficiency savings, of £0.6bn and £0.45bn respectively, but the Treasury has labelled these as ‘recyclable savings’ –meaning that these departments will not actually have their resources
budgets cut by this amount in 2010–11.”

In fact, as the budget is taken to pieces, it is increasingly being derided from every quarter. Above all else, the commentary on the budget appears to focused not on the details, but on the sheer scale of the profligacy of the government, and how it might be able to finance its massive spending plans. The revised figures for the economy detailed in the budget appear to have created a profound sense of shock to the commentariat, and the reality of how bad the situation is has now begun to sink in.

I have erroneously made a prediction of a run on the £GB, the timescale for which expired recently. Having made the error once, I will not once again put a timescale on such an event. However, this budget, the shocking nature of the soaring debt and plunging revenues, must surely mean that the possibility of a gilt strike and run on the £GB have moved that much closer. Even the most moderate of the commentators are now assuming that, at the very least, the cost of servicing government debt will rise. I had the following to say back in November of 2007, at a time when the crisis had not emerged into the full light of day:

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 I look at the 2009 budget, the one thing I do not see is the real cutting of expenditure. At the time of writing I could not imagine that the UK could reach this position and still continue to borrow and spend in the way that they are doing. That a government could be so irresponsible was beyond my imagination.

In writing this blog, I have always tried to view the actions of the politicians in a positive light, at least as far as their intentions are concerned. I have seen them as fools, but fools with the right intentions. As I look at the budget and the forecasts provided by Darling, I struggle to maintain such a positive view. I simply can not believe that Darling (and Brown) believes his own forecasts.

If this is the case, and he does not believe his forecast, the only conclusion that can be drawn from this budget is that it is a horribly misguided attempt to create a pre-election bounce in the economy. It is a budget aimed at keeping Labour in power, and is being undertaken at massive risk to the economy in the short, medium and long term.

Quite simply, it looks like the government is willing to risk the entire UK economy in a mad gamble for an electoral advantage. If so, then it is a disgrace.

Note 1: A very lively debate on the last post. As ever, the comments were intelligent and considered, and are one of the most successful aspects of the blog. I increasingly see the comments section as one of the best parts of this blog, and would guess that it is at least as much of a draw for visitors to the blog as the original posts.

Note 2: I would sincerely like to know who might be buying gilts at the moment. If anyone has any information on this, please post a comment or link. The usual source for this information is the DMO, but they will not publish on the current quarter for a long while yet. Are there any other sources that are available now? Thanks in advance for help on this.

Dinner Table Economics and Deflation

I recently mentioned that I would post an article on deflation, as I have become concerned by the way that this is being used as an excuse to engage in printing money. The idea that deflation is bad seems to be widespread amongst economists, but I am not at all convinced of this. In order to understand why, I will need to take a slightly circuitous route, which is to discuss what wealth is and how it is created. After all, economics should be primarily about how we create (and distribute) wealth.

Happily for the purpose of writing this post, I had a couple of friends come to dinner recently, and our discussion turned to economics and wealth creation. I say 'happily', as one of the friends is very knowledgeable about economics, meaning that he knows the arguments of many mainstream economists. As we conducted our discussion, it struck me that there is a fundamental problem in such arguments. It is not something that they ever say directly, but an assumption that sits underneath many of their theories and thinking. They actually think that wealth has arisen as a result of macroeconomic tinkering by governments.

As such, I thought I would start this post with a key part of understanding deflation, which is to consider what wealth actually is and how it is created. I will use some rather odd illustrations that I used during the dinner so that, as I explain, at several points it might be useful to imagine you are at the dining table with us.

One of the points which was central to the discussion, is so obvious that it should not need to be said. However, it is a point which is often lost in all of the complexity of economic discussion. The point was this:

If an economy has a total output of 100 units, it does not matter what the number of money units there are in circulation, as this will have absolutely no bearing on the level of wealth in that economy. The economy could have one hundred units of money in circulation, a thousand units, or a million units. It will make not one jot of difference to the wealth of that economy. The output will still be 100, and that output represents wealth.

To explain the point I was making, I took two wine glasses on the table and said that yesterday I, as a unit of labour, produced two such wine glasses every day. These two glasses of output were sufficient for me to live a day to day subsistence lifestyle. I then added a wine glass, and explained that due to various improvements in my ability to make glasses, I was today making three glasses instead of the two yesterday. As such, I have an additional glass which means that I have increased my wealth creation such that I can use that one glass of output for discretionary spending.

Having added the additional wine glass to my output, I suddenly have some choices. I looked around the dinner table, and decided that I would utilise that additional wine glass as a means of exchange for one portion of dessert. I designated one of my friends at the table as a dessert manufacturer. I moved my additional wine glass over the table, and exchanged it for a portion of dessert. I am now one portion of dessert richer, and the dessert manufacturer has one wine glass.

The interesting part of our transaction, however, is not immediately visible in this example. When we increase the output of a good, more of that good is available in the market. Assuming that demand is not increasing through factors such as significant population growth, then the additional supply of glasses has some interesting effects.

Before my output of wine glasses increased, the cost of wine glasses was higher reflecting the greater input of my labour in each wine glass, and the dessert maker would therefore have to pay me one and a half portions of dessert in exchange for a wine glass. Under these circumstances, the dessert maker could not afford to buy the wine glass, and was forced to use a cheap pottery mug to drink his wine. As it is now, the number of wine glasses has increased in relation to demand, my input of labour per glass is lower, such that I am now willing to exchange my additional wine glass for just one portion of dessert. The result of this change in my wine glass output is therefore as follows:

I am one portion of dessert wealthier, and the person who makes the dessert is wealthier because he can now keep a half portion of dessert that he would previously need to have given me. We have both become wealthier. Even as the exchange value of the glasses has decreased, we have both become wealthier.

The curious point in this is that, if the wine glass production had not increased, then the dessert manufacturer would not have wanted to make the exchange at all. He felt that one and a half portions of dessert was too much of a price to pay for a wine glass. My increase in output not only allowed me to increase my wealth by one dessert, but also expanded the market for my output. This is why everyone is wealthier...

If we return to the earlier point about an economy having 100 units of output, in this case I have just increased the output by one. We have 101 units of output. The economy is more wealthy, and it has nothing to do with the number of units of currency in circulation.

Returning to my increase in output of glasses, there is no necessity for me to use this addition of one glass of output to consume a portion of dessert. I can use it for many purposes. Let's imagine that I am supporting a family, and I have ambitions for my children. I want them to go to university. In order for my children to go to university, I will need to save some money to pay for the fees. As such, I forgo the portion of dessert, and decide I will save the additional daily output of wineglasses. According to many economists today, this foregoing of consumption of dessert is a bad thing....the more we consume, the wealthier everyone becomes.

However, (wisely) ignoring these economists, I go ahead and decide that I will save the one wine glass of additional output to pay for my children to go to university. I look around, and conveniently decide that the other person at the dinner table happens to be a bank. I cancelled my deal with the dessert maker, returned his portion of dessert, and passed the wine glass to my friend who is now acting as a bank. Instead of the dessert manufacturer holding the glass, the bank now holds the glass.

Why did I not just keep hold of the additional glass? After all, over the years, I could store up lots of glasses and give them to the children when they reach university age, and they can then use those glasses to exchange for all the things they need. Why did I give it to the bank?

I gave it to the bank because the bank will invest it. In this case, the bank uses the value of the glass as a means to give another producer the ability to do something new, such as increase the sales of wine. At the time I am giving the glass to the bank, one glass of wine can be exchanged for one wine glass (obviously that is the quantity of wine - as you do not keep the wine glass). In order for me to give the glass to the wine seller (a wine bar owner), I ask that the wine seller gives me a tenth of a glass of wine every day for every glass that I provide. The wine seller gets more glasses in which to serve the wine, and I get wine in return. Meanwhile, as a price for putting me and the wine seller together, the bank charges a fee of one twentieth of a glass of wine per day, per wine glass invested. We all get wealthier.

In the case of the wine seller, with more wine glasses available, he can now serve more units of wine to more people and increase output, I am wealthier as I am getting lots of wine, and the banker is wealthier because they used their knowledge to put me and the wine seller together, and they get some wine too. Just as before, the economy has become wealthier. It has nothing to do with the number of units of currency. It has to do with my increased output of wine glasses.

Now at one point, my economically knowledgeable friend suggested that we needed inflation to make people invest money, and that it was necessary to increase the money supply as the economy grows. That was why I gave the example of why I would (without any inflation) still invest my money in the bank. I also explained inflation this way:

I went back to my original choice of using my original wine glass as an exchange for a dessert; exchanging a portion of dessert in exchange for a wine glass. Instead of consuming the dessert myself, however, imagine that I am going to give it as a birthday present. The birthday is not for 6 months, so I take the dessert home and put it in my freezer. Having put it in the freezer, I am rather surprised to find that, every day, a stranger comes into my house, opens the freezer, and takes a small piece of the dessert away with them. As such, every day the dessert gets a little smaller. This is inflation. The stored value of my labour, represented by the dessert, is reducing every day that goes by.

This is one of the keys to understanding the supply of money. Every time there is an increase in the money supply, it is the equivalent of taking a little part of the value of everything from people. Where does that value go. Who is the person who is coming in and taking away a small piece of my dessert every day?

In the case of money, this is the person who makes more units of the money. Whenever they do this, they take a little part of the value of money from the existing money. In the case of the dessert, it represents the stored value of my additional wine glass of production, which is equivalent to saving x units of money. I made an exchange for one unit of dessert, and wanted to give the person having the birthday the equivalent of one wine glass of my labour. However, in a situation of inflation, the same thing happens to money as happens to my portion of dessert. Someone comes and takes a bit of it away every day. Whilst we would not accept a person coming in to our house and taking a piece of our stored value from the dessert, we readily accept them doing the same thing with our money in the bank, or money in our wallets.

In this example there is an illustration of something about wealth and money. Wealth is based upon output, and the structure of the money supply has nothing to do with making wealth, but has something to do with the distribution of wealth. Inflation distributes wealth away from you to the printer of the money. The only way to become wealthier is to produce more 'stuff' and this can be achieved without any manipulation of the money supply. This then raises the question of why there is so much manipulation of the supply of money. Macroeconomics is full of lots of complex models of the supply of money.

For the answer to this, we will leave the dinner table economics behind and turn to Adam Smith, who (as ever) got the picture absolutely right. This is what he has to say about money:

'For in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal [gold or silver], which had been originally contained in their coins [...] By means of those operations the princes and sovereign states which performed them were enabled, in appearance, to pay their debts and fulfil their engagements with a smaller quantity of silver than would otherwise been requisite.'

The cost of this he illustrates with an examination of landed estates, some of which which were awarded rent in money, and some which were awarded rents in corn. The estates with rent fixed in units of corn continued to be wealthy, but the estates with rent fixed in money became poor.

What Smith is explaining is that debasement of money serves only to help the state. Inflation of the money supply today is exactly the same in principle to what Smith was describing, and the same as someone coming in an taking a piece of my dessert.

In modern macroeconomics it appears that many economists are entirely confused about money. They seem to think that money has some mysterious purpose. If we go back to the dinner table economics, we did not need money to get wealthier, we just needed me to increase my daily output. Money has absolutely nothing to do with wealth. Money is, or should be, a unit of exchange that makes transactions more simple, and an abstraction of stored value that everybody accepts. It is the equivalent of the portion of dessert, or the wine glass - it is representation of these objects and the input of labour that created them.

The velocity of money, the number of units in circulation has nothing do with output whatsoever, it has to do with the way the wealth of output is distributed. I can not put this any more clearly than this:

Wealth is created by units of labour A, B and C producing and output of X, Y and Z.

The only difference that money makes in this equation is whether the money system offers incentives or disincentives to those units of labour to produce more or less output, and how the wealth is distributed. That is largely a factor of how much and in what way the value of their labour is expropriated through the scheming of 'princes and sovereign states'.

My knowledgeable friend was suggesting, and has argued that it is that monetary system that has allowed the growth in wealth in the Western world. My point is very clear; it is the increase in total output of labour that is the sole reason for the increase in wealth. All of the fiat money systems, and all of the rest of the apparatus of modern macroeconomics has done is play a part in how that wealth is distributed. From the dinner table economics, we can see that there is no need to create any incentives for people to get on with the useful business of increasing output and investing their increasing wealth to create even more output. The logic of these actions determines that this is what would, in any case, be what would happen.

Now if we return to the economy that has an output of 100 units, and imagine that today we have 100 units of money for that output, we can see where inflation fits in. If we then increase the money supply to 110 units, then we have inflation. The increase in the money supply has no bearing on the output, but simply means that there are more units of money relative to the output. The ten new units of money have been produced, and the value of the new units means that the producer of the new units of money have taken a portion of the value in exchange of the existing money. If you hold one of those units of money, you have just given something to the producer of the new money.

Lets imagine that the units of output also increases to 110, at the same time as the money supply increases to 110 units. Surely this is okay, as we can still buy the same number of units of output with our 1 unit of currency? This might seem reasonable, right up to the point where we start to think about where the increase in output has come from. If we think of the dinner table, it is me that has increased my output of wine glasses, so I have created the wealth. The printer of the new money has not increased output of anything, but they still have ten units more of money. This still means that my unit of money is worth less than it should be. If the additional units of money had not been created I would have been wealthier, but that additional wealth has been transferred to the producer of the new money.

But the producer of the new money has created no output....I have, and it is me that increased the output....but I see no benefits from it.

As an alternative, we can take another scenario, which is that output increases from 100 units to 11o units, but the units of money remain at 100. In this case, as my output increases, I become wealthier. My increase in output directly benefits me. I gain the full benefit of my output (the reality is however, that this is collective, not individual - everyone benefits). This is what many economists fear - deflation.

Economists say that deflation is a terrible thing. They say that it wrecks economies. If you have deflation, then people stop consuming, and stop investing.....

Let's start with the case of consumers stopping consuming. In this case, we have a good example of deflation to illustrate that deflation does not stop people buying things that they want. The example is computers which, as every year has gone by, have become ever cheaper in relation to their performance and sophistication. We all know that if we wait until next year, we will get a much better computer for our money. This is real deflation, but during a period of real deflation, the sales of computers has expanded, and expanded, and expanded.

If we think of a more mundane example, we might come up with something like a bottle of shampoo. Let's imagine that every year there are ongoing productivity gains in manufacturing shampoo such that the price falls by 3% per year. Does this mean that we will defer our buying of shampoo? Does that mean that, in order to benefit from the price reduction of shampoo, we will walk around with greasy hair.

Alternatively, we can take the case of a discretionary spend on something like a holiday. As some people will be aware, the low cost airlines have seen huge reductions in the cost of overseas travel, and the costs continued to go down over a period of years. Did this mean that people stopped overseas travel while they waited for the flight prices to drop even lower? What we actually saw in places like the UK was a massive expansion in overseas travel, as it became ever more affordable. However, this occurred despite deflating prices. This is like the example of the wine glasses....

The idea that people will not spend money during deflation is simply not true. However, if we knew that there was an unusual deflation about to take place, such that we expected the price of something to drop dramatically at some future point, we might defer our spending. For example, if the newspapers were to announce that in April of this year that there will be a new type of computer which will cost half the price of a computer today, then we would likely wait until April before buying a new computer. Moreover, when the new computers were released in April, then the sales of computers would increase as more people could afford them, and we would all potentially be richer by a factor of half a computer (if that makes sense).

However, such events would always be exceptions, and we readily buy computers despite the steady price deflation.

In short, steady deflation does not stop people from consuming.

This still leaves investment. In the case of investment, an argument might be put forward that, in the event of deflation, you could keep money under your mattress and still see it increase in value. As such, you have a disincentive to invest.

However, if we imagine that we have a situation of deflation, what has changed compared with inflation. In a period of inflation we have to invest our money just to stand still. However, we have many choices. We can put our money into a building society account and get a steady interest rate which will see a small return on our investment. Alternatively, we can put our money in a higher risk investment but risk our investment overall. In all cases we measure our return bearing in mind the rate of inflation. If we see inflation is at 3%, then we will want at least a 3% return, but most of us will want a return greater than inflation.

If we then imagine a deflation rate of 3%, that means that we will gain a 3% return on our money under the mattress. However, if someone offers us an additional 2% return over and above that 3%, we are very likely to be tempted into this. Just as in the case of the investment of the wine glass in the dinner table example, we will see that this can be a very smart thing to do with our savings. The only difference here is that it is not necessary to invest in order to keep your money, and this therefore becomes an issue of morality.

This is the morality argument; if we return to the dinner table economy, I have through my own ingenuity and efforts, ensured that I have achieved enough output to have an additional wine glass every day. This is the value of my own labour, not the labour of anyone else. The question here is, do I own the value of my own labour? What I do with the value of my labour should, as far as possible, be my own. If I choose to risk that value of labour by investing it should be my own decision. Whilst there are good arguments in favour of me making that investment, does that mean I should be compelled to invest it in order to preserve its value? If we think of the person coming into my house and taking away a piece of my dessert every day, such that I will not want to store the value of my labour in such a way, is that morally justified?

I will let you decide on the morality argument. However, what is certain is that there is no reason why deflation should lead to people not wanting to invest their money.

The final argument is that it makes the burden of debt greater. This one is a real puzzle to me. If you have a situation of inflation of 2 % and you want a 5% return, you will charge 7% to achieve this return. If you have deflation of 2%, then you will charge interest of 3%. In both cases the cost to the borrower remains the same. If you move from inflation into deflation, as would be the case now, then you have a problem in that the debt burden would increase. However, if you went from an inflation rate of 10% down to an inflation rate of 2% then the debt burden would also increase. In other words, the burden of debt is nothing to do with inflation of deflation, except for when there is a change.

What if there were a rate of deflation of 10%? The cost of borrowing would then have to go up dramatically for our example, with a 15% rate! However, if we had no increase in the money supply and the output of wealth from the economy was increasing by 10% causing 10% price deflation, I think that nobody would be complaining....everyone would be much, much wealthier...the deflation would later ease back as the supply of credit would reduce, reducing investments which might increase output...the system would balance back towards steady deflation. In other words, deflationary growth in wealth is self-regulatory and will provide a more steady model of growth in wealth.

Quite simply, I just do not believe that ongoing and steady deflation is a bad thing. If anything it is far better than ongoing inflation. Regular readers will know that I have advocated a system of money based upon a fixed specie of commodity (such as a gold standard). However, the more I have thought about this, the less I like the idea as the supply of gold also increases, such that the supply of money increases.

There is a better way, which is to absolutely fix the supply of money, such that it can never be expanded. Instead of inflating the money supply, as an economy expands, the units of currency at the start simply increase in value.

This does pose some practical difficulties, such as a unit of currency increasing in value so much that it becomes difficult to exchange for anything but ever larger items. To illustrate with an extreme example, if there were one thousand units of currency in the year 1066, then each unit of currency today hold nearly enough value to buy a city. The way around this is not to increase the units of currency, but to sub-divide the currency into smaller units. Just as today there are pounds and pence, as the value of a currency increases, it would need to be divided into pounds, pence and 'x'. At no time are any more pounds created, such that the pound is never watered down. Dividing a pound into pence does not devalue the pound, it is the increase in supply of pounds that devalues the pound.

There are many more points that could be made for such a fixed supply of currency (such as international implications), but this post has already gone way beyond my original intent. As such, I will leave it there, and leave you pondering on dinner table economics.


Note 1:

I am still getting more comments on my posts on fractional reserve banking. A brief answer to some of the comments. Yes, I agree that £1 GB is actually an IOU, and that banks also are creating IOUs. As such they are comparable. As you may have noted - throughout the blog I am casting doubts on whether the IOU that underpins the £GB and $US have any greater value as money than the IOUs of banks. In this sense, they are even more comparable than is widely believed.

However, my point about what is money always rests on a single principle, and I have explained this in several examples. Money is what people collectively believe it to be. I think I gave an example that illustrates this. A person who is starving to death will see a bowl of rice as more valuable than an ingot of gold, if he can not exchange the gold for rice. In a situation of starvation (where no food can be purchased from outside with the gold) rice would become a currency. People would exchange houses, land, or anything for the rice. It would become the currency that everybody believed in.

In the example in this post, even the value of the currency that I am proposing would be superseded by a food currency in the starvation situation.

When people were waiting in long lines outside of Northern Rock, they wanted to have their money denominated in £GB, not in bank IOUs. When they did this, they were clearly expressing their view of what money was, and that was not a bank IOU. It was a government IOU. Sadly, their belief in the government IOU is probably about to be tested as well....

The point in all of this is that when policy makers make policy, it seems a wise idea that, when they model the economic world, they have an understanding of money that conforms to the idea of money held by all of the economic actors - a reality which is expressed in the people waiting in line outside Northern Rock.

Note 2: At the dinner (on Saturday), I was explaining to a Chinese friend that her country was now the most powerful in the world, that power had shifted entirely towards China. As if on cue, Hilary Clinton is seen with the begging bowl out in China. Regular readers will know that I have been pointing to the reliance of the US on China for a long time.....

Note 3: Regular readers will also know that I have long been suggesting that the economic crisis has the potential to see the end of the Euro, and this is now the subject of speculation in the press..

Note 4:

A regular commentator 'Lord Sidcup' points out that mainstream commentators are starting to arrive at the same conclusions as my own (a couple of examples above). He asks where I can take the blog as they finally catch up.

It is a good point. I am wondering this myself, as my purpose was always to try to get a message 'out there' to as many people as possible. The blog has moved to the point where many readers (measured in many 1000s) now read each of my posts. As such I have a sense of obligation to offer something useful and that will only be the case if I can offer what I believe to be a better description of 'reality' than others. My philosophical foundation is critical scientific realism, which has helped me in this task so far.

However, if others offer the same analysis as the blog, then it might be time to call it a day. As such, I suspect that this blog may not have much life left in it. In particular, the scene is now set, and I very much doubt that anything will turn back the inevitable course of events. Whilst the exact timing of the denouement is still a matter of some uncertainty, the contradictions I have been discussing for so long must be resolved. A commentary on the detail of events will not offer anything that I have not already covered. Wealth will be still be wealth, and ongoing economic delusions that are the subject of this blog will remain delusions.

The populists, the something must be done politicians, will flail around for solutions, all the while doing more harm. The general populace will still think that everything might be 'fixed', without accepting the reality of what is actually broken. The fundamental problem is that the reality of the underlying problem is something that is hard to accept. This is the idea that we are no longer wealthy enough to live as we have before....unless we accept reform, and very tough reform.

At this stage, I am less and less sure of what I can add, and have had this thought occur to me several times recently. I will give this subject some thought. Comments welcomed.

P.S. Lord Sidcup, I am glad to hear that you read Marx and Adam Smith. Smith, is quite astonishing, and I have long suspected that one of the problems with economics is that all economists are comparing themselves to his ghost.

Note 5: I had a considerable amount of traffic on my posts on QE, and hope that many letters were sent to MPs. My thanks to those who took the trouble. I find it very disturbing that a significant (historic proportions?l) policy might take place under such conditions of opacity. Let's hope somebody pays attention.....

UK Bank Bailout - Round 2 Begins?

The main post today is quite brief as I would like to catch up on some of the questions and comments from previous posts. I have been reading the news and it is ever more apparent that the bailouts of the banking system are really just not working. I had the following to say on the subject in June of 2008:

In particular, the problems with credit and the banks are going to reach their real crisis in about six to eight months time. The reason is that the fallout of the sub-prime fiasco is just the start. The next phase will be the consumer credit crisis and the SME crisis - and the results will be equally as dramatic, but with the added pain of hitting the banks when they are already suffering severely.

So what are these crises. The first is that consumer credit was already reaching breaking point, where many households were borrowing to repay borrowing. This was, in any event, unsustainable. Added to this factor, the story of inflation needs no more retelling. Finally, we have the spectre of rapid increases in unemployment, and it will be this development that will spark the second banking crisis. In particular the number of delinquent loans will start rising rapidly as unemployment increases, and accelerating concerns about the already weak balance sheets of the banks will see even greater tightening of credit conditions. Furthermore, unemployment will see even more mortgage defaults, and the banks will be trying to sell assets into a falling market. Quite simply, their losses are going to be staggering.

The second problem will come from the Small / Medium size businesses. As the economy turns down, think of the small traders - such as restaurants, who are already only marginally profitable. These will rapidly fail, in many cases leading to losses for the banks. Even the medium size companies, with a better financial base, are going to be negatively effected by the consumer downturn, and their failures will hurt the banks even more.

Remember that these problems are going to hit the balance sheets of banks when they are already tattered, and hit the reputation of the banks when their reputations are at a low.

I said all of this before the huge bailouts and nationalisations. The truth is that the government was always going to have to keep pouring money into the black hole of the banking system. I had the following to say in September, at the time the bailouts were being justified to 'get the banks lending to each other':

The reasons that the banks are not lending to each other is that they all know that they are all holding toxic debt. This is not just CDOs etc. but also fast deteriorating commercial debt, unsecured consumer debt, and old fashioned mortgage debt (held on devaluing assets with people with ever more insecure job prospects). Furthermore, the sources of liquidity from the East are drying up as confidence in the 'rich world' banking system is evaporating.

And finally, I had the following to say in October, having discussed lending into a falling market, and the attempts by government to push the banks to lend.

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.

I could go on quoting such commentary, but I hope that you get the picture. In the first quote I suggested that the second crisis would be in 'six to eight months time'. That was in June, and we are now at the point in time that I predicted that the second crisis would hit - and all the major news papers are highlighting that a new bailout is imminent (e.g. Times, Telegraph, Guardian). The Times says the following:

Under one option, a “bad bank” would be created to dispose of bad debts. The Treasury would take bad loans off the hands of troubled banks, perhaps swapping them for government bonds. The toxic assets, blamed for poisoning the financial system, would be parked in a state vehicle or “bad bank” that would manage them and attempt to dispose of them while “detoxifying” the main-stream banking system.

And from the Guardian:

Banks and building societies are being deterred from lending by the worsening economic outlook and the fall in house prices and other assets against which loans are secured.

Over the last month, we have articles reporting that the problems in mortgage repayment are spreading to 'prime' borrowers, reports of increasing insolvencies in the retail and service sectors... the articles in the links are just a random sample. I could go on, but the news is best expressed in the necessity of the Telegraph to publish an article on how to avoid repossession of your home.

All the while this is hitting the banks when they are already struggling with battered balance sheets, and it is going to get a lot worse yet....

This raises the question of how much the government can pour into this black hole, and takes us right back to the money printing scheme that is the last desperate attempt to stem the tide. With the government sitting on the boards of major banks, they will certainly be aware that the balance sheets of their 'investment' are, even as I write, falling off a second cliff. As I sit here typing I am listening to 'Ne andrò lontana', and it seems somehow appropriate background music for this post.

The trouble with the banks has only just started, and there is much more pain yet....

Note 1: I will try to address some of the many questions that I have been neglecting. I will work backwards from the most recent, and apologise that I will only be able to get so far....there have been a very large number of comments of late (my inbox is overflowing), many of which have (as ever) been extremely good.

I will start with the comments on my post on government or market responsibility for the crisis. I am unsurprised that, in the current climate, my post is causing some controversy. Unlike just about everyone, my post exonerates the market.

From anonymous there is the suggestion that, rather than bailing out the banks we should do the following:

'I'm sure there are science(physics) and humanitarian projects that could chew up several hundreds of billions of dollars without too much problem probably over the next 10 to 15 years but at least it will inject large amounts of cash into the world and people won't have to pretend to work to get government handouts but actually do some real work with real future benefits.'

Whilst agreeing that pouring money into the pit of the banking system is not the best use of the money that is being borrowed, my answer is quite simple. Do not borrow money when the problems you are experiencing are as a direct result of .....borrowing money. However the money is spent, it must be paid back, and that means a future contraction in growth. We can not spend the same money twice - if we spend it now, we will not have it in the future. Yes, it would be better to spend the money on something else, but the real answer is not to spend money you do not have. If you read the other sections of the blog, you will see why this is the case...

Jeremy (an increasingly regular commentator) makes the following comment:

'Isn't the best end-game for China to wait until the US stock-market bottoms and then buy all the best assets with their huge $ reserves?

They don't want the US to go bust, but they want it cheap and they might not want to buy dodgy motors from them but they'd probably be interested assets like Silicon Valley.

If China invested $1 trillion in US companies then there would be plenty of americans with enough money to buy chinese exports again and China would eventually end up owning the US lock, stock and barrel.

Just a thought. '

A very good thought. If China were to use the money to buy US assets, it would help buttress the $US for a while, but it would not help in solving their current domestic contraction. Furthermore, once the money was used, the US would still be left in a position of not having enough to sell, meaning that the $US would in any case fall. China would then be left with substantial losses on its assets - albeit at the benefit of increasing their economic power. The point of my post is that the problems lie with how they can ameliorate their collapsing export market, and that problem is short-medium term, and one which risks the very stability of China overall. They would also face a backlash (protectionism) if they started buying up the high-tech assets that you refer to in any significant quantity. However, as I said, a very good thought.

I have had an interesting question from anonymous, as follows:

The point about China's accumulation of Treasuries is that most of them stem from the last couple of years, so even if they were to be worthless soon, the Chinese have the process mechanisms of creating that wealth again quickly.
Also, how is it possible that China can seemingly subsidize its economy to gain such an advantage over the whole world when its economy is in fact still only a fraction of total worldwide output, i.e. how can a government with such comparable resources manage to create such a huge distortion? That seems very odd.
Furthermore, how far worse of would Western consumers be without cheap Chinese goods? As far as I know spending in America has gone down for consumer goods but massively increased for government-distorted things like health-care and housing.

I am afraid to say that the trade imbalances with China remain, even as the economies of the West are contracting. China makes many products for the budget end of the market, and are therefore relatively well placed to continue to export. In more cost conscious times......

The subsidy question: There are many forms of subsidy that China can use. One of the subsidies that I highlight is the subsidy implicit in their currency manipulation. In this case, the subsidy is collectivised over the whole economy. In keeping their currency low, they are effectively removing purchasing power from every individual in the country, and every business. It is actually an indirect taxation. This is quite difficult to explain in short but I will try. When a consumer walks into a shop in China to buy a pen, the artificial exchange rate will make the pen made in the US x% more expensive. The indirect taxation on purchasing is the difference between the price of the US made pen in the situation of a free floating currency and the actual price today with the fixed exchange rate (y). The person is 'y' poorer as a result of paying that indirect tax.

Although you suggest that China is only a small part of total world output, the size of the (so called) output of countries like the US and UK is overstated by huge amounts (I estimate at least 30% for the UK), as the output of such countries includes output that is resultant from debt. One of the major creditors for that debt is actually China. If the lending by China to the US was retained within China, for example used as it has been in the West for consumption, there would be a significant rise in the output of China, and a commensurate fall in output in the US. This is actually what is happening to US output - as the credit taps switch off, their 'output' is falling. I suggest a read of this post to explain it more clearly. This is not to include the critical consideration of relative strengths of currencies in the consideration of output. For example, UK 'output' has been falling both absolutely but also because of the weakening of the currency.

I will leave the answer there, though much more could be said...I think most of the detail is scattered through the blog.

Another anonymous poster asks the following:

"Our creditors, such as China and Saudi Arabia, are now turning off the supplies of credit, and are no longer buying the £GB to lend to us. Demand from this source will continue to evaporate..."

Could somebody briefly explain the mechanichs of this? How did they lend to us? By buying Government bonds?

The short answer is 'yes', they buy bonds, and a range of other forms of assets. A full analysis of the situation can be found here. A quote from this discussion is:

China’s low (controlled) interest rates imply that, since its reserve holding are believed to be held primarily in medium- and long-term industrial country treasury instruments and government agency bonds.

However, there are many other factors that need to be accounted for, such as 'round-tripping' (setting up a fictional Hong Kong entity for a mainland company), and the report details this better than I can in a short answer. However, you will note how opaque it all is....The tables at the end of the article are the most useful part (tables 7,8 and 10 if I remember correctly), and these will give you a detailed answer.

Another anonymous poster questions the idea that the market is a good thing, suggesting that government will always need to intervene:

As I see it, in a finite world and an exponentially increasing population, unfettered markets won't cut the mustard, unless of course you are prepared to throw millions of losers overboard.

If we look at China, it was a 'fettered' market before 'opening'. Millions of 'losers' were already 'overboard', and have been rescued by markets. As I have always emphasised, the world has overall become considerably richer overall since China opened, but the problem for the West is that, not only has the world become richer overall, but there is also an ongoing redistribution of the wealth towards the emerging markets.

A simplistic way of illustrating this can be seen in the car market. In the West there has been massive growth in the luxury brands of cars such as Mercedes. It became conventional wisdom that the best place to be in the car markets was the upmarket brands, which explains why Ford invested so heavily in European luxury brands. This is a perfect illustration of the imbalances that are now becoming evident. It is now, as the wealth of the world redistributes over more people, that we see the emergence of the Tata Nano, and the amazingly cheap Renault being sold into Central European markets.

There are more people with more wealth, but that wealth is divided over more individuals, making these cars a type that best serves the market. The luxury brands are looking increasingly vulnerable as the shift in distribution of wealth occurs. However, in the long term, as the wealth distribution runs its course, the demand for these luxury brands will return. The question to ask is where that demand might originate?

Lemming asks many questions and raises many points, as follows, so I will need to quote in full:

'I am persuaded by your view that government intervention is a distorting element which prevents the free markets from functioning 'properly' - and your idea that we need less, not more, banking regulation seems to be 180 degrees opposite to the view of every other economics commentator I have read, recently, by the way.

But I am still worried that there are other distorting factors which might render "the invisible hand" useless. One such is the way that money is issued: is the free market system meant to be stable regardless of how money is issued? In your post you suggest that growth and recession are both natural conditions for the economy, but I cited Eddie George speaking to the Treasury Select Committee in a comment a few days ago, stating that the BoE had pursued a policy of unsustainable lending rates in 2000/2001 to avoid "recession", as though that condition was to be avoided at all costs. Why? Is it because almost all money in circulation is temporary and therefore growth must be maintained otherwise the system collapses uncontrollably? Certainly a condition of recession is assumed by most economics commentators to be a huge problem. If our version of free market capitalism is set up to depend on perpetual growth, then in the real world of finite resources, it must fail eventually, and you have often given the example of a temporary bottleneck in the supply of oil limiting growth. Is continual growth a prerequisite of free market capitalism, and if so, does this example, alone, negate the validity of free market capitalism in principle?

(And how about the fact that interest rates are set 'manually' in our system of fractional reserve banking? It seems to be a very crude government intervention in itself, yet "the invisible hand" is supposed to be self-regulating and shouldn't need any external control to function.)

Another distorting factor must be the free markets operating on commodities whose availability and price do not vary by supply and demand. There is a frequent commentator on CiF called 'physiocrat' who continually refers to the problem of land in the economy and points to this website: www.landvaluetax.org. I suspect he is probably right. Surely a commodity such as land is a huge fly in the ointment of free market principles? '

The first point is that I am increasingly alone in defending the markets. To this I would highlight that I was in a very lonely (though apparently not completely alone), when predicting this crisis. It certainly seems that the mainstream are all becoming increasingly interventionist. This is in part because they look at the symptoms, not at the cause of the symptoms. They see that there has been lunacy in the banking system, and think that this lunacy is the result of a free market. However, they do not ask why it is that people were happy to place their money so blindly in a system that was simply not working. They do not ask why there was such a flood of capital in the first place. I could go on, but I do not want to repeat my post. They are quite simply not asking the right questions.

With regards to the question of stability and instability. Should economies be stable, and should the governor of the Bank of England be trying to manipulate the economy to avoid recession at all costs?

I will illustrate the need for instability from my experience in China. When I first arrived there was a boom in the manufacture of televisions to supply into the China market. There was massive growth as ordinary Chinese people tipped over the financial point where they could afford this item. That emerging demand saw the emergence of large numbers of manufacturers, all of whom responded to the market demand, and provided ever cheaper and better televisions. In the early stages, no doubt, many were making good money. However, as more and more companies entered the market, the market became flooded, and the bust then happened. All of the new entrants saw the potential for profit, but ended up destroying those profits through oversupply. The only answer was a rash of bankruptcy in order for the market to reach an equilibrium (in this case the over-supply was exacerbated by local governments jumping into the market with their own investment in production). At the end of this process considerably less businesses were left standing, but those businesses would be the strongest businesses, operating with the best products to meet the demands of the market.

Such an example shows how markets can boom then bust. In the process a lot of people purchased consumer durables, and future industrial giants started to rise. The bankruptcy of the other companies was a necessary part of that process, but would have led to a lot of people also losing money, as well as people losing their jobs. However, you are left with an industry where the output is actually geared to meeting demand, and the companies meeting that demand are the most efficient in their overall operations.

Lemmings' other questions largely pertain to the status of commodities within a free market. These are a critical element, as without commodities, the market can not expand. The trouble arises with many commodities is that, during times of growth, it often takes a while before new commodities come 'on stream'. As such, what often happens is that commodity supply lags growth, such that the growth in commodity supply comes on stream just as a spurt of growth comes to an end. If we think of the television example as a proxy for world markets, the cycle of that sudden growth and bust was over (I guess, but am not sure) about five years. If we think of this example, and imagined that component suppliers needed to build new factories to supply the components for the television (equivalent in this example to commodities), the extent of the boom would only become truly visible in about the second year of the boom. If we imagine that this fictional component required two years to build a factory, it would only come on stream as the boom is about to collapse, leaving the factory with excess capacity.

However, if the next boom is in hi-fi, and the components the factory makes are suitable for hi-fi, then the factory will benefit from the second boom. The trouble is that, whilst awaiting the second boom, they lose money. Commodities suffer from the same problems. The problem recently was that the dumping of so much labour into the world market so quickly just left the ability for commodity producers to keep up as an impossible task.

As for the question of land, the Economist gives a good example of where 'land' rights ensure that land is utilised well. I have not read the full report in the latest edition which is on rights in sea fishing (my print edition has not yet arrived) but, when you give rights to the sea to individuals/companies, they seek to preserve the value of those rights through better management of the fishery. The original report I read dates back a while, but can be found here. I am sure that the new report in the Economist will have similar examples.

Regarding Property Tax: I have read some of the property-tax arguments briefly, but do not have time to discuss these in depth on this occasion. However, I will quote something from the home page of the website Lemming pointed to as follows:

It would operate as an annual charge on the rental value of land, assuming that each site was in its optimum permitted use

I will leave you to work out why that might be problematic in this proposal, but the words 'who' and 'how' come to mind. I checked their FAQ, and looked briefly elsewhere, but found no answer.

I have a had a few comments from the curiously named B33ENN (?), who asks in one post:

If there is a Western economic collapse on the horizon, meaning China's export economy fails along with us, what effect would having a surplus supply of real and valuable raw materials have on China's internal economy? What effect would their fast-track education in modern technology have on their internal development?

At that point, would they really need or want anything from us at all? If they learn to produce everything for themselves, from low-tech to high-tech, what would they need to trade with us and our worthless currencies?

The question then becomes, is China really viewing itself as part of a world economy? Or is it exploiting the benefits while it can, all the while more interested in its own internal wealth and future, independent of the world?

China has a long history of supposedly being isolationist, but their moves towards the development of a blue water navy, the quest after commodity supplies around the world tells us a different story. China simply does not have the access to the materials they need to function as a modern economy. For example their major oil fields are close to exhaustion (I forget the name of the oilfield, but I am thinking of the one in which a revolutionary hero, 'Iron Man Wang', sprang from).

Perhaps an interesting perspective on the rise of China is the argument that China is just returning to its 'natural' status in the world. This is the argument found in 'The Great Divergence' by Kenneth Pomeranz. I think his argument is very poor in places, but would agree with the central principle that China does have a natural 'weight' in the world. He ignores that this weight has been achieved by the greatest and most enduring imperial expansion in history, and there is nothing to say that China will not seek to continue this pattern of growth and expansion. It is very easy to forget that China is an empire, and is therefore not as isolationist as perhaps is commonly perceived. The nature of China's growth may be simply towards economic expansion, but any idea of it taking an isolationist approach is very unlikely.

With regards to trading with us for our 'worthless' currencies, it is at this point, when our currencies are 'worthless' that we might be in a position to once again return to growth. At that time, we will all be much poorer, but will therefore be more competitive. In the most basic terms, our workers will be demanding less of a return for their labour, a return closer to that of an equivalent Chinese worker, allowing for us to sell our goods. However, as I have emphasised, we will also need to reform ourselves broadly in order to return to growth, and that is something detailed throughout the blog, and which I will not cover here.

Note 2: At this point, I have to offer my apologies, but I must call a halt. I have answered the questions in order, so I have not made any particular determination in which questions I would answer. I mention this, as there have been many other excellent questions and useful comments that I would like to respond to...Sorry for some rushed answers, and I hope that they are as clear as I would like them to be.

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.

Economic Crisis - The Mainstream Starts to 'Get It'

If you are new to the blog, I recommend starting here.....as this will introduce you to some of the key ideas on why we are in the current economic crisis.

An unusual post for the blog, in that I will express some frustration, but hopefully the post will also serve a purpose. Regular readers will know that the economic crisis has so far almost perfectly corresponded to the course of events that I predicted. I did not predict the economy through some mystical process, but quite simply by always keeping in mind Adam Smith and ignoring the views that were so obviously without any logic or consistency. I just asked if the condition here is x, and over here it is y, what will follow? It really is not very complicated - none of it ever was. It just required shutting out the nonsense that was endlessly bombarded on us all from the 'experts' and various commentators. It just required thought....

I have not been alone in suggesting that the Western economic system is in deep trouble, but I have felt very alone in the explanation that I have given. I am now pleased to say that people are starting to recognise at least part of the problem. I quote from an FT article as follows:

'Asia’s part in America’s financial downfall has been two-fold. First, shiploads of cheap goods from China and other low-cost producers helped keep a lid on US prices. That lulled the Fed, with its tight focus on the consumer price index, into thinking it could have it both ways: high growth with low inflation'

And

'While it lasted, China and others were able to grow at supercharged rates by lending to Americans so that they could import its products.'

I can remember, about three years ago, sitting in on an economics lecture and describing this process with an analogy of a conveyor. Strangely enough, after my explanation, everyone in the class 'got it'. I described how, if you took one piece out of the system, the system would shut down, and that the consequences would be dire. If a class of people (without an economics qualification between them) could 'get it', it makes me wonder how this has come as a surprise to so many people, in particular people who should know better, and who are often paid large amounts of money for their insights. It is very puzzling indeed.

I never stop reminding myself of the price that this (foolish and avoidable) crisis will extract from so many people. The foreclosures, the bankruptcy and unemployment that are now going to hit the UK and US like a storm. It is when I think of this price that I feel some resentment at those who had the opportunity to prevent this mess. If I could see what was coming, why were they unable to? Or did they suspect that this was going to come, and just pretend that it would go away - enjoying the sunshine and pretending that the storm clouds might just pass by. I doubt even this explanation.

However, unlike a few people out there, I do not believe that this is a grand conspiracy of the government or international bankers. I quite simply do not believe that they are competent enough to manage something like this. In fact, I would take comfort in the idea that the economic crisis was the result of a master plan, as at least it would suggest that there was some intelligent thought at the commanding heights of the economy. The conspiracy theorists try to scare us with the ideas of cunning and clever shady and secretive groups. How much more scary is it to just accept that those that lead the economy are just incompetent?

To illustrate how incompetent, I will give an example that I have mentioned several times in this blog. It is the measurement of GDP. This measure takes overall economic activity as a measure of the health of an economy. What it does not measure is the source of that activity. All I did was ask a simple question; if we are borrowing huge amounts of money from overseas and we add in the multiplier effect, are we seeing GDP growth resultant of growth in debt, as magnified through the multiplier effect? I then checked the rate of growth in debt, and the growth in GDP, and there it was. Over the last ten years (which is as far as I ever looked) growth could be explained almost exclusively by growth in debt. I did not have the time and resource to do calculations, but it was not necessary, as simple heuristic (guesstimation) made the scale of the problem clear. It is very simple - look at the growth in the GDP of the UK and look at debt growth together, then consider how every time you spend money it multiplies activity in the economy (through the company receiving your money paying various suppliers, wages etc.)

From this simple idea, we know that the UK economy MUST contract back to at least 10 years ago, but it will probably contract further because the economic conditions at that time were far more favourable (e.g. China was still not a major player, and we were not saddled with the hangover of the debt binge). This is not clever and not complicated.

I hope that, as I explain this, you will sense why I am frustrated. It really is not rocket science. It is all based upon very simple ideas. It is something that we could teach to a monkey. So how did so many get it wrong?

I also hope now that you are concerned. The reason for this post, aside from expressing my frustration, is to point out that the same people who managed to fail to understand these very simple ideas, are the people who are still proposing the solutions. They are the same politicians, economists, bankers and all the rest of the people at the commanding heights of the economy, who are still in charge.

For example, just about everyone now accepts that the US and UK have a problem with debt. Despite this, they still are proposing borrowing more. Have a look at my last post to see the simple lack of thought, lack of connection to reality involved in this decision. In the last post I am again addressing the problem with simple principles, and once again, it is not rocket science. The analogy is imperfect, but it is difficult to argue with the principle that, when mired in debt, taking on more debt is not going to be the solution. No charts, no complex equations, no volumes of theory. Just a little bit of reason....The only circumstance under which any borrowing should be made, under the current circumstances is for (real) investment, or for natural disaster, or war.

I have mentioned that the mainstream is starting to 'get it'. However, even now they have not understood that we have hit a brick wall of commodity supply, and that we are entering an era in which competition for resources has created a 'zero sum' game, complete with winners and losers. They do not 'get it' that the Western economies can not recover unless there is serious reform, because they are simply less and less able to compete. The devaluation of currencies (which has a long way to go yet) in comparison with the currencies of the 'emerging economies' will eventually deal with the trade deficits, and re-balance the wealth to realistic levels (the West will be poorer). However, in order for the economies to really start to generate wealth again, this will not be enough. The bloated fat of government, waste and endless regulation have to be addressed and resolved. In order to win in the coming era of intense competition, borrowing more money, saddling the Western economies with yet more debt, is just about the worst thing that a government can do.

When I wrote my essay on the state of the economy, and the prospects for this crisis last November, I held a vague hope that someone would read it and think it through. I sent it to a member of the Conservative Party (Boris Johnson), hoping that somehow it would make a difference ( I can be foolish too). It did not.

As I said, a frustrated post. The people making the decisions, are still getting it terribly wrong, and ordinary people will pay the price for their poor understanding. How can the message get through?

Note:

I have been reading with a sense of puzzlement the latest twist in the crisis. This is the Irish Republics decision to guarantee all of their bank deposits, rregardless of size. It is a quite extraordinary gamble. I wonder whether they knew that such a move would attract offshore money seeking safety, but bearing in mind rumours of an imminent Irish bank failure this looks more like panic, and is therefore probably a happy unexpected consequence.

As with all such actions, there are potentially large prices to pay. The first is that, it may force other countries to follow suit, thereby creating a domino effect, where everyone has to do the same in order to avoid (the very important) deposits going overseas, in which case it will force every country to take an extraordinary risk with their finance. In other words Ireland has attracted deposits, thereby shoring up their own banking system, but at the risk of destabilising other banking systems. More to the point, what happens if banks do collapse in Ireland?

We can run through some scenarios (not predictions). What if, for example, the UK followed the Irish approach. Is it not possible that the money that is flooding in would flood back out? Might this sudden loss of deposits start a panic (even though they were additional business since the crisis). In doing so then there may then be a collapse. Alternatively, as the money comes out of the institutions, if they were weak and only being supported by the fresh deposits, might the progressive withdrawal push them over the edge (that they were in any case facing prior to the new deposits). However, this may happen midway through the outflow, and thereby saddle the Irish government with the bill for guaranteeing foreign depositors.

On the plus side, if Ireland is the only country that takes this course of action, they may actually have achieved the miracle of shoring up their financial system (at least in the short to medium term). No doubt some pundits will then start to suggest that the Ireland solution is appropriate elsewhere, conveniently ignoring that the solution only works if it is a point of differentiation, otherwise it just serves to expose the government to horrendous liabilities.

In the meantime it is a solution that has the effect of weakening the banking systems of countries that have not implemented the same measure. Not a very good solution all round.... but they may get away with it if others choose not to follow.

Note 2:

Meanwhile the bailout continues to make painful progress towards passage. I rather liked this quote from the FT:

'In a move intended to shore up confidence in banks, the legislation would give the US’s Federal Deposit Insurance Corporation the unlimited ability to borrow from the Treasury for a temporary period.'

Confidence in the banking system being gambled with confidence in the government finances. An interesting trade.

Meanwhile the real world continues the plunge over the precipice entirely disregarding bailouts, and excitement in the financial centres. Just one example in the news is that 'UK House Price Fall Most on Record'. The same article details further falls in the £GB, and another article reports that M&S are suffering tumbling sales. In other words, whilst the financial world looks to the magic wand of the bailout, the reality on the ground is grinding away at the roots of the debt driven economy.