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?

China - What Future?

When you visit a Chinese bank, you will likely be presented with a series of buttons that you can push so that you can rate the service level of the cashier. The buttons, of course, are there to encourage the cashiers towards good service. The reality is that the buttons should be marked from 'surly' to 'downright obnoxious'. The state owned banking systems, despite the best of efforts, remains unreformed.

It is only a few years since the Chinese banking crisis, when the Chinese government bailed out the banks and placed their mountain of bad loans into a special fund. My question is; has anything changed since then?

The answer, in the opaque world of Chinese business, is that no one will know until the government decides it is time to know. In a previous post I pointed out that the Chinese construction boom may be a bubble. In particular, large numbers of apartments are being built, and individuals are investing in them only to leave them empty. One of the curiosities of Chinese property is that, as soon as a person has lived in an apartment, the value of the apartment falls. The result is lots of investors are leaving apartments empty in the hope of the value of the apartment increasing. This looks very much like a bubble.

In addition to apartments there are the endlessly multiplying malls and department stores. In an expanding economy, it may be that there is a real demand for these. The question is whether there is the demand for the numbers that are being built. I can only comment on the city I lived in (Xi'an), but it did appear that the construction was already outstripping demand and that this did not seem to deter new construction starts.

In light of this, I must conclude that there may still be some suspect lending from the Chinese banks. This is pure speculation, but is based on experience 'on the ground'. This raises the possibility that there is also bad lending into business, in particular to the state owned firms. Such lending is not so visible, so it is impossible to say if this is the case. However, if there is bad lending into construction, it is not too great a leap of imagination to think that other lending may also be bad. Having said this, if it does go wrong, if the banks have been lending poorly, then the Chinese government has the finance and will to bail out the banking sector. As such, whilst a risk to the Chinese economy, the danger of bad lending is more that it will hurt the economy, rather than a banking crisis destroying the economy.

On the other side of the equation there is a growing, and aggressive private sector, often managing to grow their businesses without any help from the banking system. Go to a Chinese province such as Guangdong, and you will see the reality of such businesses. For example, I lived for a while in a city called Zhongshan, which is now supplying the majority of the world's lighting. Just outside the main city is a town with literally hundreds of factories all devoted to manufacturing and selling lighting. It presents international buyers with an incredibly competitive one-stop shop. As for lighting in Zhongshan, the same for many other markets. They nearly all have similar clusters.

In effect China is creating clusters of excellence, where whole cities or districts are specialising in particular products and markets, and doing so in a highly competitive way. This allows all of the benefits of network effects, whilst creating an environment of incredible cost efficiency. Each cluster generates its own supporting infrastructure, and economies of scale. Each firm is continually looking at its neighbour, and any new technology, new process, will spread rapidly through the cluster.

This kind of arrangement is very common, and may be part of the reason for the success of Chinese manufacturing. It has certainly turned China into the old cliche of the 'workshop of the world'. We are now all aware of the resulting exports.

The big question for the future of the Chinese economy is how their economy will cope in the coming recession. If we think of the area of Zhongshan that manufactures lights, what will happen when the export orders start to decline? We know that, in a housing market downturn (crash) less people will move house (a time at which people are likely to buy lighting), and that there will be less house building, less office construction and refurbishment and so forth. Export orders will certainly decline.

It is at this point that we come to a big question mark.

The Chinese economy may, or may not be, at a point where internal growth within China has the potential to take up the slack. Has it yet reached that point? It is very difficult to say. It is a finely balanced point, but the economic growth of the coastal areas is now being replicated in the interior. Can the growth in the interior maintain the momentum of the coastal cities? The Chinese government has huge reserves to draw upon should the economy falter, and may seek to use those funds to further develop the interior of the country. There is also an ongoing and dramatic process of infrastructure investment which may help carry China through the bad times.

Furthermore, China has being making ever stronger inroads into markets such as Africa, and South America. Whilst these can not replace the US and European markets, they may serve to ameliorate the effects of a downturn.

As you will note, there are many question marks here. There are many 'experts' in China trying to wade through the piles of figures trying to see what will happen with China. The trouble is that many of the statistics are either opaque or suspect. In this situation, it is just as well to rely on intuition.

In one respect, if China remains stable, we can be sure that China will continue in growing its share of the world export market, even if the size of the market overall declines. China, as has already been mentioned, has benefits of scale. In addition to this, it still has a large untapped pool of labour which will serve to provide labour for growth for many years yet.

In the point above, I have mentioned stability. This is one of the big question marks over China's future. The Chinese government relies upon economic growth and nationalism for its legitimacy. If the economy does falter, and this brings hardship to the rising Chinese middle classes, then there is real potential for instability. With over 100 million often discontented migrant labourers, disenchanted ex-military (traditionally they leave the military and go straight into a comfortable job in a state owned enterprise, but this has stopped), even more disenchanted peasant farmers, all that is needed is a discontented middle class leadership to create an explosive situation. And a spark.

So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before. In the meantime the Western world needs to accept that it is no longer in a position to continue with its complacency. China poses a real and ongoing threat to the world economic order, and will continue to grow at the expense of the West, unless the West responds by restructuring of their economies through (real) improvements in education, lowering their cost base, and taking an aggressive approach to intellectual property and fair trade (for why, see here).

Note: I am sure that many readers would want a more firm outlook for China. However, in the case of China, sound information is lacking. As such, it is difficult to see how anyone can really predict what will happen next. The worrying part about this is that China is increasingly important in the world economy, and therefore what happens there is of great importance. Such a large question mark means that policy formulation becomes less certain.

The Plot Thickens

A very quick post today, as I am rather pressured for time.

The first thing I would like to do is to recommend an article in The Times, which is called 'The Credit Crisis in Black and White'. It is a very simple and effective explanation of the problems of bad mortgages. However, the problem that this highlights is just one of the problems in the banking system and, as I have pointed out before, a second credit crisis is looming on the horizon. In particular, as unemployment picks up there will be a new wave of defaults which will include a melt-down in the consumer credit markets. There is an awful lot of lending out there that is about to go sour, and the problems will extend well beyond the sub-prime markets.

As predicted in my essay 'A Funny View of Wealth', the unemployment rate is now accelerating fast in the UK, despite the return home of many of the Central European workers (which I also predicted as likely). The Telegraph today reports that there has been the highest monthly rise in unemployment since 1992, and also reports expectations that the rate of rise is likely to accelerate:

'Vicky Redwood, economist at Capital Economics, said: "Expect the labour market to weaken further - we see the unemployment rate rising to 8pc eventually from its current 5.2pc, equating to a rise of 900,000."'

I am afraid that these figures are very conservative. My own personal expectation is that the situation will be far worse than this prediction. My own guess (and it is no more than that) is that, if we ignore the 'make work' schemes that the government will inevitably introduce, the figures over the next two years will climb up to a minimum of 10% and a maximum of 20%. If I were to pluck a figure out of the air, I would settle on 14%. However, such figures would also be ignoring the structural unemployment in the form of those who are allegedly too sick to work.

The other interesting (and worrying) news being reported is that there is increasing nervousness about financing deficits in the US economy. The assumption has been that the Western economies are 'safe', but that illusion is now being shattered. The results of this awakening are going to be very profound. In particular, the Western economies are going to have to start paying a high risk premium for their borrowing. The taps on cheap financing are now going to close, and this will add further impetus to the economic slide. One of the major impacts will be that the flow of inward investment will dry up as I detailed in 'A Funny View of Wealth':

'In particular, the economy of the UK has become ever more dependent on inward investment to act as a counterbalance to the imports of goods and services that have led to consistent balance of payments deficits. As the UK economy slows there is a realistic possibility that such inward investment will also freeze. One of the reasons for the ongoing inward investment has been the apparent robustness of the UK economy, and in particular the perceived stability of the UK economy. As such, one of the other inflows of money into the UK economy might also dry up, further leveraging the UK economy downwards.'

As the illusion of success fades, so will many sources of finance. When considering the future of the UK economy, I sometimes need to remind myself that there is no limit on how bad it might become. As I have said in an earlier post, it is necessary to forget the assumption that the economy of the UK (or US, Europe) have a right to wealth.

It seems that the world is now waking up to this fact, and looking on the Western World with ever more cynicism and, I am very sorry to say, they are right to do so. The situation is going to get very, very bad indeed.