The Rating Agencies

There is a fascinating piece of news that I have just stumbled upon in Bloomberg, regarding the EU and the ratings agencies:

Credit rating companies face curbs on when they can assess government debt and restrictions on their ownership under draft plans agreed upon by the European Union to limit the industry’s influence and tackle conflicts of interest.

Investors will also get the right to sue ratings companies if they lose money because of malpractice or gross negligence in the plans agreed upon yesterday by lawmakers from the European Parliament and Cyprus, which holds the rotating presidency of the EU.

The interesting point here is that the Basel banking regulations entrenched the ratings agencies within the financial system. Essentially, the ratings agencies became the key to the level of capitalisation of the banking system. The small detail that the ratings agencies were paid by said same banks to undertake the ratings did not cause concern in the bizarre world of banking regulation. No doubt there will be many who will applaud the EU for taking action against the agencies; they really are, in some respects, the guys with the black hats. However, we must also remember that their power in the market was underpinned by a regulatory framework; the Frankenstein that created this monster was the regulators.

The problems with this latest move from the EU is that it does not seem to be founded in a genuine motivation for reform, but rather to de-fang the major ratings agencies, which are coincidentally downgrading sovereign debt. One suspects that the motives here are not entirely about the aim stated in the article, which is about 'financial stability'. The reason I am doubtful about the intentions is that the stated aim is to address conflicts of interest. This is the most simple problem to fix, and does not require this rather odd approach. It is so absurdly simple to fix the conflict of interest that the solution given absolutely must have different motivations; the absurdly simple answer to resolve conflicts of interest would be to ban any rating of any financial product that is paid for by the issuer of the product. It does not matter whether the product is a personal pension, or a complex derivative product.

Also, with regards to sovereign ratings, this is one of the few areas where (relatively) there is little conflict of interest. How curious is it that this is the focus of the attention of the EU? The following passage from Bloomberg tells the story:

On sovereign debt ratings, lawmakers and officials agreed that each credit rating firm must pick three days a year when they would be allowed to give so-called unsolicited assessments of governments’ creditworthiness, according to Jean-Paul Gauzes, a lawmaker involved in the talks. Ratings firms may get a chance to issue unsolicited ratings -- those that haven’t been requested and paid for by a client -- outside those dates if they can justify it to regulators.

“Credit rating agencies will have to be more transparent when rating sovereign states, respect timing rules on sovereign ratings and justify the timing of publication of unsolicited ratings,” Barnier said. “They will have to follow stricter rules which will make them more accountable for mistakes.”

Here we have the distinctly curious situation of the lawmakers seeking to restrict the access to the ratings when the ratings are paid for by entities that need an independent rating; it is the very opposite of the absurdly simple solution to conflict of interest. Just as the rating of a derivative should be paid for by the potential purchaser, the same with bonds. In this case, this is exactly what the ratings agencies are doing. They may be useless at their job, which is not the point of this post, but they are in this case presumably acting in the interest of the purchasers, not the issuer. This is how the system should work, but that is what is being attacked. In summary, this is simply an attempt for the EU to try to bury the crisis that is threatening the EU and the Euro project.

The news should be greeted with outrage, but the visceral ant-ratings agency feeling will probably see applause from many quarters. Whilst I would like to see the agencies de-throned, this is not the solution, and it tells us more about the terror being felt in the upper echelons of the EU than it does anything substantive to fix the agencies.

Default Exposure

The European Pantomime

As each day goes by, the pantomime in Europe reaches new levels, with a 'firewall' that will not contain the crisis, a 'firewal'l that will encourage the spread of the fire, yet more crisis summits, and the farce of the Greek referendum that was then wasn't. Perhaps the most absurd part of this is the attempts at arranging a 'haircut' (so many metaphors) on Greek bonds that will not trigger credit default swaps, which is a form of insurance on debt default. This from Bloomberg:

Confidence in the credit-default swaps market may be undermined by the European Union’s plan to resolve the euro region’s sovereign debt crisis.
The EU said yesterday that it reached an agreement where banks will write down their holdings of Greek bonds by 50 percent. The International Swaps and Derivatives Association’s chief lawyer later said because the deal agreed to by the Institute of International Finance is considered voluntary, it won’t require firms that sold a net total of $3.7 billion of credit protection on Greece to pay buyers of the swaps.

[and]

“If they find a way to avoid a trigger event in the CDS, then people will doubt the value of credit-default swaps in general, leading to more dislocations in the market,” said Pilar Gomez-Bravo, the senior adviser at Negentropy Capital in London, which oversees about 200 million euros.
German Finance Minister Wolfgang Schaeuble is among European politicians who have expressed concern that the contracts have worsened the euro region’s troubles. Speculators can use them to benefit as a nation’s creditworthiness declines because the price of the insurance they offer rises.

There is something distinctly odd in this. First of all, this increases the likelihood of contagion, and the EU is seeking to force a haircut on the banks that hold Greek bonds, but at the same time is in a panic about the impact of sovereign defaults on the European banking system. Does this not seem odd, bearing in mind that some of the issuers of CDSs are US banks?

As the European financial crisis worsened during the first half of 2011, U.S. banks increased sales of insurance against credit losses to holders of Greek, Portuguese, Irish, Spanish, and Italian debt. Guarantees provided by U.S. lenders on government, bank, and corporate debt in those countries rose by $80.7 billion, to $518 billion, according to the Bank for International Settlements.
BIS doesn’t report which firms sold how much or to whom. Almost all of those guarantees are credit-default swaps, according to two people familiar with the numbers who asked not to be identified because they weren’t authorized to speak. Five banks—JPMorgan (JPM), Morgan Stanley (MS), Goldman Sachs (GS), Bank of America (BAC), and Citigroup (C) — write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. A credit-default swap is a contract that requires one party to pay another for the face value of a bond if the issuer defaults.

In other words, if CDSs were triggered, some of the pain would be passed on to non-European banks. Is this not the purpose of CDSs, to spread the risk more widely and reduce the exposure of individual institutions. The problem is that, the total exposure and the holder of that exposure is opaque, and we cannot be sure where, in complex networks, the real exposure lies:

A possible antidote is better disclosure about counterparty concentrations. Big banks aren't likely to do this on their own for fear peers won't follow suit. So it's time the Securities and Exchange Commission stepped in, calling for disclosures on counterparty concentrations and standardized information about country risks.
The big five banks mostly gave extra disclosure on their European exposures in third-quarter earnings. But each took a differing approach. The firms, aside from Goldman, did show how much CDS they had purchased against exposures to Piigs countries—about $20 billion in total. Lacking, though, was any detail about counterparties, other than vague assurances like it was purchased from "predominantly investment-grade global banks." Without more information, the protection is suspect.
Granted, banks would likely balk at providing detail on even high-level counterparty exposure. For one, they may fear this additional information could highlight how much risk rests in a small group of about a dozen or so big, global banks. And they will be quick to point out that the additional information they've so far provided has hardly helped reassure investors.

It is a certainty that central banks and the regulators in the US and Europe have a good idea about the concentrations of risk in the system, and they are no doubt briefing and driving the policy of politicians. This is all so opaque, and one can only suspect that the avoidance of triggering CDSs is yet again about 'too big to fail'. In other words, the world is being moved again by policy to protect large financial institutions and the 'investment-grade global banks' are investment grade only because they are backstopped by governments and central banks.Is this not shabby? Comments welcomed.....

Smuggled US Bonds in Italy - An Update

The Smuggled Bonds

I am getting a considerable amount of traffic to my post on the smuggled bonds in Italy, and you may wish to read the original and the comments at the end if you have not already done so (post here).

Since my post the US has finally confirmed that the bonds are fake:

WASHINGTON, June 19 (Reuters) - A purported $134 billion in U.S. government bearer bond certificates seized by police near the Italian-Swiss border are fake, the U.S. Treasury said on Friday.

"Based on the photograph we've seen online, they are clearly fake. And not even good fakes," said Stephen Meyerhardt, a spokesman for the Treasury's Bureau of the Public Debt.

However, the actual details on this story remain very patchy and contradictory which is still giving me pause for thought. Who are the two individuals, why did the confirmation that they were fake take so long, what were the forgers trying to achieve with such apparently useless bonds? Just to add fuel to the conspiracy fires, it transpires that the two individuals with the bonds have been released from custody without charge! The reason given is that they did not try to pass off the bonds as genuine.....

This seems very odd.

Another concern is that the original reason for my belief that the bonds were forged was an article detailing a bond forgery operation in the Philippines, which appeared to match the bonds that were found. This from the FT:

Whether the men are really Japanese, as their passports declare, is not entirely clear, but Italian and US secret services working together soon concluded that the bills and accompanying bank documents were most probably counterfeit, the latest handiwork of the Italian Mafia.

Few details have been revealed beyond a June 4 statement by the Italian finance police announcing the seizure of 249 US Treasury bills, each of $500m, and 10 "Kennedy" bonds, used as inter-government payments, of $1bn each. The men were apparently tailed by the Italian authorities.

Yesterday the mystery deepened as an Italian blog quoted Colonel Rodolfo Mecarelli of the Como provincial finance police as saying the two men had been released. The colonel and police headquarters in Rome both declined to respond to questions from the Financial Times.

In the story above, it is apparent that the 'authorities' were tailing the men, but the original story proposed that they were stopped in a random check. This is a very different story to how the men were intercepted to that which was previously released. Of course, it is possible that this is just more details being released, but the original stories appeared to be quite clear.

The article above goes on to detail another related scam, involving $1 billion in bonds in relation to the Venezuelan central bank. The scale and nature of the fraud detailed looks very different from the case in question. This is rather odd:

Italian officials, while pointing out that hauls of counterfeit money and Treasury bills were not unusual, were stunned by the amount involved. Investigators are looking into the origin and destination of the fakes.

Last month Italian prosecutors revealed they had cracked a $1bn bond scam run by the Sicilian Mafia, with the alleged aid of corrupt officials in Venezuela's central bank. Twenty people were arrested in four countries.

The fake bonds were to have been used as collateral to open credit lines with banks, Reuters news agency reported. The Venezuelan central bank denied the accusations.By FT staff in Rome, Tokyo, New York and Washington

Not only are they not connecting the bonds in this case to the Philippines forgeries, they are proposing the mafia are responsible. This seems highly unlikely. I really can not believe that the mafia are that idiotic. According to one unnamed US official, the bonds included a picture of the space shuttle, even though they are dated from a time long before the space shuttle. And the mafia were involved in such stupidity???

In the last two years, Italian authorities have seized some $800 million of U.S. bonds in the Como area in northern Italy.

Meyerhardt said U.S. government investigators believe that the seized bond forgeries were made using commercial photo enhancement software to alter the image of a $100 bill to increase the amount into millions or billions and add what appear to be interest coupons.

Another U.S. official said the seized bonds were purported to be issued during the Kennedy administration in the early 1960s, but the certificates showed a picture of a space shuttle on it -- a spacecraft that first flew in 1981. Some of the bonds were purportedly issued in a $500 billion denomination that never existed.

This really does not sound like a mafia operation....

Had the news simply confirmed the identity of the individuals, and linked them to the Philippines forgery operation, I would have quietly accepted the story as a simple piece of idiocy. However, the muddying of the waters does give me some concern. I am not inclined to conspiracy theory but, as one commentator pointed out, governments do indulge in skulduggery. I am still not convinced that there is something amiss here, but there is also nagging sense that all is not as it appears. I can not quite convince myself either way. The FT Alphaville article on the latest news also appears to share this sense of unease.

Altogether, this is a very, very odd story. I do feel like I am sounding a little bit like a deranged conspiracy theorist, so please feel free to comment on whether the latest news makes sense to you.

However, I do not want to just focus on the bond story, and thought I would also add some commentary on other news that is current. As such, some other points follow:

Protectionism

The first story that has struck me, is the 'Buy China' rules being implemented in conjunction with China's stimulus measures. As you would expect, the rules are not quite as crude as the 'Buy China' quote suggests. The Chinese government are doing implementing this policy indirectly by asking that any imports used in the stimulus must first have a government permission. In other words, there is an administrative barrier to trade that will no doubt work in conjunction with nationalist sentiment.

As one article makes clear, this appears to be (at least in part) a tit-for-tat response to the 'Buy US' policy in the US, and that this kind of trade discrimination is, in any case, not something new:

China's World Trade Organization commitments require it to treat foreign and domestic goods equally in commercial trade. But Beijing has not signed a WTO treaty that extends such requirements to government procurement, which might limit options for challenging Beijing's "Buy China" order.

Beijing has imposed similar requirements on government projects such as China's giant Three Gorges Dam to favor domestic suppliers of equipment and services.

Ambrose Evans-Pritchard in the Telegraph calls this a 'suicidal' policy, and suggests that it hints that the Chinese recovery is not as strong as has been suggested. If China were to pursue such a policy, in an attempt to protect domestic jobs, it will provide ammunition for those who have been pushing for restrictions on trade with China.

It is hard to disagree with Ambrose Evans-Pritchard, but lurking beneath this may be a reason why China has taken such a bold and inflammatory move. It might just be a signal of the confidence in China that, with their massive holdings of US debt, they hold the whip hand. It could simply be a sign that China now sees the US as impotent, and that China's position allows them to dictate the terms of trade. This is not to say that suicide thesis is wrong, as it is quite possible that China has made a miscalculation, but rather that the possibility of Chinese confidence should not be ignored. We are not privy to the meetings behind closed doors between the governments of both countries, and can only guess at how the shift in relative economic power has actually played out.

What is certain from this latest move is that a significant impetus towards wider protectionism has now taken place. How it plays out may be very significant to the outcome of the economic crisis, but this will rest in the hands of political decisions, rather than any underlying economic drivers.

Instability

A short while ago, I was discussing how there may be wild swings in sentiment, due to investors being unable to decide on a place of safety for their investments. Below is an article on treasuries over the last few days:

TOKYO, June 17 (Reuters) - U.S. Treasuries fell on Wednesday as investors took profits from a four-day rise and avoided adding positions ahead of a Federal Reserve policy meeting next week.

The benchmark 10-year yield had fallen near 3.65 percent on Tuesday, after climbing as high as 4 percent last week, helped by weaker data on manufacturing and industrial output which in part caused a two-day stock slide this week.

Still, price falls were limited as investors continued to unwind trades made on economic recovery hopes and sold stocks and commodities, and shifted some funds back into safe-haven debt.

Prospects of further Fed purchases later in the day after the central bank bought $6.45 billion of Treasury debt on Tuesday also provided some support to the debt market.

But investors were unsure about the direction for Treasuries once profit-taking runs its course, as views remain that the economy has seen the worst of the recession and before hearing the Fed's stance on bond buying at its two-day meeting next week after a spike in long-term yields this month.

I have highlighted this story, as it illustrates the nature of markets at present. They are, quite literally, in a funk of uncertainty. Nobody is entirely sure of the economic data or the economic situation.

Likewise, the roller-coaster ride of the £GB continues, with this story from Bloomberg:

June 17 (Bloomberg) -- The pound dropped by the most in almost two weeks against the euro as stocks retreated and minutes showed Bank of England policy makers voted unanimously to continue their asset-purchasing program.

The British currency also slid versus the dollar after a government report showed claims for U.K. jobless benefits rose in May. The minutes of the central bank’s June 4 meeting showed policy makers decided it was too early to know if the measures designed to lower borrowing costs were working. The FTSE 100 Index fell to its lowest level since May 5, losing 1.2 percent.

“Stocks have been pummeled today as we shift toward a more risk-averse mentality and that’s conspiring to hit sterling,” said Jeremy Stretch, a senior currency strategist in London at Rabobank International. “The pound never does well in this sort of environment.”

The pound weakened 0.8 percent to 85.01 pence per euro by 5:05 p.m. in London, after earlier sliding as much as 1.2 percent, its steepest intraday decline since June 4. It depreciated 0.7 percent to $1.6296.

Claims for jobless benefits rose 39,300 to 1.54 million last month, the Office for National Statistics said today. A broader measure of U.K. unemployment climbed 232,000 to 2.26 million in the three months through April, the statistics office said. The Confederation of British Industry expects the jobless total to peak in the second quarter of 2010 at 3.03 million.

If you review the day to day news that pours from Bloomberg and Reuters, it is apparent that the wild swings seem to gyrate as positive indicators are followed closely by negative indicators. As each 'green shoots' story emerges, another closely follows pointing in the opposite direction. What then appears to follow is a wild swing in sentiment. However, the underlying trajectory of the OECD economies continues in a downwards direction.....making a mockery of each swing to illusory safety.

Fiscal Responsibility?

Perhaps the Bank of England has recognised that it can only prop up the bond market for so long. In a recent speech, the governor has made an explicit call for fiscal responsibility from the government.

The news follows on the heels of the G8 conference, in which exit strategies from stimuli were a subject of debate:

June 15 (Bloomberg) -- Group of Eight finance ministers began drawing up contingency plans for rolling back budget deficits and bank bailouts as the economy shows signs of recovery and investors start worrying about inflation.

Officials meeting in Lecce, Italy, over the weekend said it’s prudent to consider what exit strategies to deploy once global growth is secured and asked the International Monetary Fund to examine how to do so without reigniting the two-year crisis. At the same time, they said it’s premature to rein back more than $2 trillion in stimulus packages.

“Growth should remain the principal focus of policy,” U.S. Treasury Secretary Timothy Geithner said after the meeting ended on June 13. “It is too early to shift toward policy restraint.”

Policy makers trod a fine line in the knowledge that withdrawing stimulus measures too soon could choke the recovery before it starts, and allowing them to last too long might push up borrowing costs. They are also trying to reassure markets after the yield on the 10-year U.S. Treasury note rose last week to the highest since October.

“Markets aren’t looking for specific exit strategies now, but want governments to start thinking about them,” said Bill Witherell, chief global economist at Cumberland Advisors Inc. in Vineland, New Jersey, which oversees $1 billion in assets. “They worry that inflation is going to build up if nothing is done to withdraw the stimulus.”

The interesting point in all of this is that there is an admission implicit in this discussion. There is currently no solid plan of how or when it will be possible to reverse the massive measures taken to support the financial system and 'stimulate' the economy.

As an analogy to this we might think of a corporation going to a bank during troubled times to consider further lending. The bank might ask how long and how severe the downturn might be, and demand firm timescales for when and how the company will turn itself around. If sales are low, where will the new sales come from, if costs exceed revenues, how might the differences be resolved, if there are new competitors stealing market share, how might they regain their share? What new products are in the pipeline, when will they come to market, and what will their impact be on revenue?

Many, many posts ago last year I made a comparison between the US economy and the US automotive manufacturers. The comparison still stands, but now with the story of GM as an indicator of the inevitable ending when basic questions can not be answered. The US economy is in the same place as GM was when the first bailout of GM was issued. The answer at that time given by GM was that company would use the money to tide them over until they worked out a plan for restructuring....in the case of governments, they are not even beholden to any timetable on when they need to even put the plan together. They will get around to it at some point in the future.....

That people like the chief economist at Cumberland Advisors accepts this situation is more than a little baffling. However, I must accept that this is the world view of many who are driving markets. If these people were to have reviewed the situation of GM, they would not be looking at long distant economic performance, but the recent record of failure, and how that failure might be turned to success again. However, in the case of the US economy, they seem to see the equivalent of GM in 1950...and imagine that such long past performance would be an assurance of success for GM now.

Returning to the Bank of England, whilst disagreeing with them on so much, it is at least encouraging that they are pressing for answers from government, albeit whilst adding to problems by continuing to print money to support the financial system.

Anchoring goes Mainstream

In a current Telegraph article, it seems that Tom Stevenson may have picked up on my adaptation of Dan Ariely's anchoring theory.

There are many reasons why those decisions are invariably irrational. These heuristics, or psychological biases, are beginning to be unpicked by the new science of behavioural finance.

One is "anchoring", the tendency of people to measure the value of an asset against some wholly irrelevant number. A study of this asked groups of people to estimate the number of doctors in London but only after they had first provided the last four digits of their phone number. People with the highest phone numbers consistently gave higher estimates of the number of doctors. Completely irrational, of course, but no different from fixating on RBS's share price two years ago when assessing whether it is good value now.

You can find my articles in which I discuss anchoring here and here. Of course, Dan Ariely is well known, and this could be coincidence. However, it would be nice to think that the posts on this blog might seep into the mainstream.

Inflation (again)

For regular readers, it will come as no surprise to find that CPI inflation is above expectations, according to a Telegraph article. As expected, the price of imports is now feeding into the prices of goods on the shelves. Apparently, there are something like £10billion worth of price increases on their way, according to a PWC report (no link for this). I have consistently argued that there will be no deflation for this reason.

In a very odd article, the Telegraph a few days ago came up with an alternative index of inflation, in which they proposed the UK was seeing deflation at -10%. On viewing the figures, it is apparent that the key variables are oil, the price of which again can be partly attributed to the £GB and partly to price rises out of the UK's control, and housing costs, which have been directly influenced by interest rates. The reason for publishing such an article, is completely unclear.....there is not even a source for the figures. Meanwhile a Mail article from April tells a story of soaring prices, according to their own index.

The reality is that, the CPI is the key index for the Bank of England, and the long promised deflation against the index has still not materialised. However, this was one of the great justifications for printing money......I guess that they might (at a push) claim the policy is working, but am not sure that they would want to bring attention to the policy in this context, in case it be subject to serious scrutiny.

Note 1: I am hoping to write an article on a fixed fiat currency system, and will try to put the thoughts that have appeared in different posts into a single post. I am not sure that the idea of a fixed currency could work, but my thoughts on the idea are becoming increasingly positive.

Note 2: I am publishing this in a bit of a rush, so I hope that there are no errors. Please feel free to identify any problems.....

Japan Secretly Selling Smuggled $US bonds?

I need to be very clear before writing this post that it is highly speculative, if not fanciful. As such, I would caution readers to view the post as some wild speculation.

The cause of the speculation is an article on Bloomberg, as follows:

June 12 (Bloomberg) -- Japan is investigating reports two of its citizens were detained in Italy after allegedly attempting to take $134 billion worth of U.S. bonds over the border into Switzerland.

“Italian authorities are in the midst of the investigation, and haven’t yet confirmed the details, including whether they are Japanese citizens or not,” Takeshi Akamatsu, a spokesman for the Ministry of Foreign Affairs, said by telephone today in Tokyo. “Our consulate in Milan is continuing efforts to confirm the reports.”

An official at the Consulate General of Japan in Milan, who only gave his name as Ikeda, said it still hasn’t been confirmed that the individuals are Japanese. “We are in contact with the Italian Financial Police and the Italian Public Prosecutor’s Office,” Ikeda said by phone today.

The Asahi newspaper reported today Italian police found bond certificates concealed in the bottom of luggage the two individuals were carrying on a train that stopped in Chiasso, near the Swiss border, on June 3.

The undeclared bonds included 249 certificates worth $500 million each, the Asahi said, citing Italian authorities. The case was reported earlier in Italian newspapers Il Giornale and La Repubblica and by the Ansa news agency.

If the securities are found to be genuine, the individuals could be fined 40 percent of the total value for attempting to take them out of the country without declaring them, the Asahi said.

The Italian embassy in Tokyo was unable to confirm the Asahi report.

I placed a comment against my last post on first reading the story, in which I speculated on what might be going on, and suggested the following:

If the bonds are genuine (unconfirmed), the big question is who might have such a large sum? The only logical answer is a nation state, and with the individuals being Japanese, that would suggest Japan.

The second question is why they are smuggling them?

I have been speculating on this subject and have come up with some wild scenarios. I would like to emphasise that these are 'wild'.

However, the best answer that I could find is that the Japanese government wants to dump US bonds on the quiet. As such, they sought to transfer them to Switzerland, where they could then sell them, and disguise the point of origin of the selling.

In doing so they would avoid spooking the markets by making a Japanese sell-off of US bonds visible. As a large holder of US debt, any significant sell-off would potentially commence a $US rout.

This might make sense, but why would the smugglers go via Italy?

This is all wild, wild speculation, and it is still unconfirmed that the bonds are genuine.

However, if the bonds are genuine, I can see no other logical explanation. In the (unlikely) event that such speculation were correct, it really would be the start of the end of the $US.

I had picked up the article about the smuggling in my regular trawl through the financial news. A short while after writing the comment, I found an article reporting on the G8 meeting.....which is located in Italy.

This means that senior Japanese financial officials are in Italy, and these are the very people who might wish to undertake the quiet dumping of bonds. I was unable to find out who was attending from Japan, but it is a certainty that it would include all the necessary key players necessary for this kind of undertaking.

Regarding the matter of whether the bonds are genuine, this from the Asia News:

Italian authorities have not yet determined whether they are real or fake, but if they are real the attempt to take them into Switzerland would be the largest financial smuggling operation in history; if they are fake, the matter would be even more mind-boggling because the quality of the counterfeit work is such that the fake bonds are undistinguishable from the real ones.

What caught the policemen’s attention were the billion dollar securities. Such a large denomination is not available in regular financial and banking markets. Only states handle such amounts of money.

Please note that these size of securities are only used in state to state transactions. The problem then arises as to why any counterfeiter might forge such instruments? It is not like forging a $US 100 bill, where it might pass off in a shop. In this case, if you try to use this kind of forgery, then whoever accepts it is going to want to know 100% for certain that it is genuine. They will certainly want to know a lot about it, and no forgery is therefore likely to be of any value whatsoever. As such, why forge such an instrument?

In the meantime, the Japanese have suddenly started talking up the prospects for the $US:

June 12 (Bloomberg) -- Japanese Finance Minister Kaoru Yosano said his government is confident about the outlook for U.S. Treasuries, signaling the second-biggest foreign holder of the securities will keep buying them amid record sales.

“We have complete trust in the fact that the U.S. views its strong-dollar policy as fundamental,” Yosano, 70, said in an interview in Tokyo on June 10 before attending a Group of Eight meeting of finance ministers starting today in Italy. “So our trust in U.S. Treasuries is absolutely unshakable.”

It could be argued that this public statement contradicts any secret selling of US bonds. However, if you are about to dump a large amount of US bonds into the market, the best way to cushion the impact might be to boost the value by suggesting that there is a strong buyer in the market. The fact that the alleged buyer is in fact a seller will not be known until much later. In the meantime, Japan gets brownie points from the US administration.

In all of this, it should be remembered that Japan is the world's second largest holder of US treasuries. Any public selling by Japan would therefore result in a $US crash, and would wipe out the value of much of the value of Japanese reserves. Back in January, I was discussing the $US dilemma for the major creditors of the US as follows:

The trouble is that, with so many countries holding these $US reserves, most of whom have their own economic problems, it is likely that everyone is having the same thoughts, and confronting similar problems. What you have is a situation in which there is something like a Mexican stand-off. As soon as one starts selling, then everybody must start selling. They are all, at the same time, terrified of selling, because in doing so, they destroy the value of what they are selling. It is a time bomb just waiting to go off.

Selling the bonds without appearing to sell them would be an excellent solution to the standoff. On the one hand you can sound positive, continue to make purchases, reassure the market, and meanwhile offload ever more of the dangerous (toxic) assets through the back door.

Normally, such massive amounts of assets would be impossible to move without regulators noticing, and without alarm bells going off. However, if it is the government and central bank acting, there is no reason why the alarm bells might not be switched off.

For the moment, let's assume that this wild speculation about the story is true. If it is the case that the men who have been arrested are acting in order to commence a sell of US bonds, it is quite likely that they will either be government finance officials, or members of the Naicho (Japanese intelligence service - reports to the prime minister). If it is the former, then a link can be made to the government but, if the latter, then it will be difficult to ever establish a connection.

In the meantime, how will the US and Japan handle the situation, if the bonds are real?

The important point is that it is not in the interest of either country to admit to the operation. For the US, if they point the finger at Japan, they will need to admit that one of the largest holders of bonds is dumping them, and this will cause a run on the $US. For the Japanese, their interest in not revealing what they have been up to is self-evident. If the bonds are genuine, it will need one or both of the governments to confirm that they are genuine. It is in the interests of both governments to deny that this is the case. The most likely story will be that it is a North Korean counterfeiting operation, as they are well known for this kind of activity.

Meanwhile, the Italians will be unable to prove the case one way or another. Without confirmation of the authenticity of the bonds from the US or Japan, how might they establish the truth one way or another? In addition, it is unlikely that the Italians would want to upset the US by pushing the matter.

In short, whether the bonds are genuine or not, I would be very surprised to see that this story goes much further.

The underlying story, if this wild speculation were to be true, is that the Japanese are dumping the $US. If this were the case, then the $US is finished, and we can expect to see it collapse in the very, very near future.

As I have said, this is all wild speculation. However, it does have a kind of painful logic. If the Japanese are, like the Chinese, increasingly dubious about holding $US reserves, then this would be a way of unloading the position whilst gaining the maximum value from the holdings. I have long argued on this post that $US bonds are largely worthless, the Chinese suspect that this may be the case, so why not the Japanese? As another example, Peter Schiff is discussing the absurdity of Japan having faith in the $US.

Once again, I can only emphasise that what I am writing is highly speculative. I have no evidence either way, but can see no other explanation of this rather extraordinary story. If anyone has a less fanciful explanation, then I will welcome comments. This is all very odd, and I do feel that my 'take' on it is quite questionable. It really is moving into the realms of James Bond movies....questions to answer, in particular are...; Is there any reason why anyone might want to forge the bonds? Who, and how might they pass them off? What mechanism might they use to sell the forgeries?

Over to you, the readers, for alternative considerations....

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.

It's Official - The UK Government is Now Bankrupt

You would think that news that the UK government is bankrupt would be headline news around the world. When I quote the piece of news that announces the bankruptcy, you may say 'huh?', and like the newspapers, initially find it difficult to see it. I will start with the news itself, which was tucked away in the financial section of the Telegraph:

'Charlie Bean [the Bank of England Deputy Governor] put his weight behind the pound's 25pc fall over the past year in an unusual comment on the pound. Mr Bean also confirmed that the Bank is poised to start buying government bonds in a drastic attempt to resuscitate the stricken economy.'

If we translate this, it means is that the Bank of England is going to print money to directly finance the operations of the UK government. This is the action of a government that is now literally bankrupt. The bank is not going to buy the bonds to 'resuscitate the stricken economy' but will buy them because nobody else wants to buy UK government bonds. There are not enough people willing to lend to the UK government. It is bust. It is bankrupt.

The UK government can not fund itself without borrowing - it can not service its existing debt without borrowing, and it can not pay for its activities without borrowing. When the lending stops, it goes bust. Or it prints money.

You will have read lots of stories that 'quantitative easing' (printing money) is being undertaken to fight deflation, but it is not. It is the last desperate gamble of governments to save themselves and their collapsing economies. For those that believe that printing money and lending it to the government is about fighting deflation, read on....

In July of last year, I posted that I believed that the UK government was effectively bankrupt, and that this would reveal itself as the coming crisis progressed. Ever since that early post, I have watched in horror as the UK government has poured ever more money into ever more and ever larger bailouts. In July of 2008 I had this to say:

One certainty is that, in a years time, the UK banking system will still be in crisis, as will be government finance. Unemployment will still be climbing, consumer confidence will be rock bottom, and house prices still falling. Businesses will be closing down in large numbers. All of these events were put in place over the last few years, and can not be reversed.

I identified that the first bailouts would be followed by even greater bailouts, and that the banking crisis would simply be transferred onto the government. As just one example, I asked the following at the start of September:

The reality is that the UK has been bailing out the banks for some while, through the special liquidity schemes. How long can this go on?

This was before even more money was poured into the bailouts. I then went on to say in the same post:

In the case of the UK, I wonder whether the UK government will have the financial wherewithal to actually have a choice in the matter. When the next credit crisis strikes, I expect confidence in the UK economy to be at a very, very low point, and the only way the government will be able to finance the bail outs will be through 'printing' money, with all of the negative consequences that entails.

As a sense of perspective, this was written at the time of the bailout of Fannie Mae and Freddie Mac in the US (I have added the italics in this quote). The situation that I predicted at that point in time is exactly the situation that is now confronting the UK.

In recent months I have also been pointing out the impossibility of continued government borrowing. In particular, just about every country in the OECD is going on a massive borrowing binge, and all at the same time. My question is very simple - how are all of these governments going to simultaneously raise the money to finance their borrowing? The US alone is looking to raise $US trillions. In such circumstances, potential lenders will have a huge range of choice on where they put their money, and they will look to put their money where they believe it will be safe.

As we are all aware, the £GB has been plunging in value, the UK is seen by many as the economy that will be hit hardest by the economic crisis, and (even before this article) was discussing the option of printing money. Amongst all of the choices of which country to lend to, the UK is going to towards the bottom of the list. At the same time, due to the lunatic and endless bailouts, government borrowing is spiralling ever higher. At a time when there is intense competition between countries for finance, with an ever growing need for ever more borrowing, it is inevitable that the UK government would be unable to continue to borrow enough money.

As a result, the printing presses are about to turn....

Back in December of 2007 I wrote a post called 'Money Printing Economics - the UK and US as the New Zimbabwe?'. At the time I wrote this, I could still put a question mark on the end of the sentence. This is what I said at that time:

Now we come to the crux of it. If the government prints enough money, this will provide an potentially unlimited amount of liquidity to the banking system, and the banks can then use that money to buy government debt, thus financing government borrowing. Meanwhile, the government can continue to service its expenses and keep repaying the debt owed to overseas creditors. In other words, the government will appear not to default. However, overseas investors will not see it this way. They will see it as it is - a default. Instead of failing to repay, they will be repaying the debt obligations in what can only be termed 'comedy money'.

As it is, the government is not even using the banking system as a conduit for the printed money, but will be financed directly by money fresh off the 'printing press'. Putting the situation bluntly - the UK is now the new Zimbabwe.

I have, in many posts, discussed the results, implications and consequences of printing money. If you would like to know how a central bank prints money, I give an explanation in Note 2 at the end of a post which can be found here. However, the method is not important, and it is just as easy to think about the central bank as if it were printing money by printing physical bank notes, as the effect is exactly the same.

I will try to explain what printing money actually means, through simplifying the process (for regular readers of the blog, you may want to skip the explanation, as I have explained this before). As we are all aware, the UK has an output of goods and services in many sectors. However, for the sake of simplification, I will just use the example of milk, and will describe the UK's output as if it were only milk, and will use small numbers to make it as clear and as easy to understand as possible.

In this illustration, we will say that the UK has a total output of milk of 100 litres, and that there is a total amount of £100 in the UK economy. In this example, therefore, the price of milk will be £1 per litre. If we then imagine that the government prints another £10, so that there is a total of £110 in the economy, we have a problem. The amount of milk has not increased at all, but the amount of money available to buy milk has increased. Instead of having £100 chasing the 100 litres of milk, we now have £110. In this simplification, remember, there is only the 100 litres of milk to buy with the money.

The only thing that can then happen is that the milk will increase in price from £1 per litre to £1.10 per litre. In other words, if you increase the money supply without increasing output, then you have a situation of inflation.

In addition to this, printing money has lots of other nasty effects. The first of these is that printing money is a form of taxation, and I will explain how this works.

As we have noted from the milk example, if you print money without increasing output, you are effectively devaluing money. Yesterday, your £1 could buy you a litre of milk, today that is not possible. If you are devaluing money, where has the value gone? The answer is that part of the value of your £1 has been transferred onto the newly printed money. If you then ask who has this newly printed money, you see that it is the government that holds it. As such, what you have is a situation in which the government is placing a tax on every unit of currency, and transferring that tax into the newly printed money. This means that there is a tax on every coin and banknote in your pocket, a tax on every £1 that you have in your bank account, and a tax on every asset that you hold that is denominated in the £. In other words, it is a tax on everything.

Another effect of printing money is that it a method for governments to default on debt. If you imagine that you are an overseas investor, and you have lent the UK government £1, then the value of that money was equivalent to being able to buy one litre of milk (using the milk example again). If you imagine that the government is running out of money, so that it has only £0.90 left to pay the lender, they will have a choice. Either they can pay back part of what they owe the investor, which means partially defaulting on the debt, or they can print money and give £1 to the investor. In the case of giving the lender £0.90, this is not enough to by a litre of milk, which means that the lender has lost money. However, if the government prints money, as in the example I gave earlier, then the investor will have his £1 returned, but it still will not buy the litre of milk, as milk has increased to £1.10. In both cases the effect is exactly the same, and in both cases the government has defaulted on debt.

Essentially, however it is spun, government money printing is fundamentally dishonest.

Then there are the effects that this has on an economy. Before discussing this, I have seen a lot written about Japan, and how they managed in recent times to print money without subsequent hyper-inflation. This is given as a justification for why it will be okay to print money in countries like the UK, and the US. If you go to my post here I explain why Japan 'got away with it', and if you go to the notes at the end of the post I explain why countries like the UK will not 'get away with it'.

Returning to the effects on the economy, we have established that inflation follows money printing. This is a situation of monetary inflation, where the output of goods and services is not increasing, but where the number of units of money chasing those goods is increasing. What then happens is that the cost of living goes up, as everything becomes more expensive. In a situation of a collapsing economy (the case of the UK), many private sector workers will be very upset at seeing their standard of living eroded, and some of them may be brave enough to strike and demand more pay. Many others will not, as they will fear for their jobs. However, some of those strikers will actually get more pay. That increase in pay will feed into higher costs and eventually higher prices for the output of their sector. This is inflationary.

In the meantime, government workers will also be upset at seeing their standard of living declining. The difference here is that, they will not have the same fear for their jobs as the private sector, and will therefore be more likely to strike. As they are in the position of running 'essential services', and/or the unions in this sector are strong and powerful, they are very likely to succeed in gaining pay rises. If we remember why the government is printing money in the first place, which is because it can not afford to pay for its commitments, it becomes apparent that this will be very problematic. The government is already unable to pay these government workers without printing money, so paying them more means that they will have to print even more money......which further feeds into inflation.

All the while this is going on, the government is effectively devaluing the currency, such that on foreign exchange markets the value of the £GB will be falling. As the value of the £GB falls, the cost of all imports will climb. Again, you have substantial inflation. On top of this, as the inflation starts to kick in, you start having capital flight, which is where people realise that the value of their money is being destroyed, so that they seek to put their money in other currencies that are more likely to hold their value. In order to do this, they will have to sell their £GB in exchange for other currencies, which means that there is a flood of £GB into the world market, which in turn further pushes the value of the currency down even faster and harder. This in turn feeds into higher inflation, and the situation becomes self-perpetuating into a downwards spiral.

So what will the government do with inflation out of control and a collapsing currency? Inevitably there will be widespread discontent and hardship that results from this inflation. The government is in a position where they believe they must 'do something'. On past performance, based upon the way that they have systematically destroyed the UK economy such that they created the situation, they will yet again do exactly the wrong thing. They will try to command the economy back into shape. In order to do this, they will impose controls on international capital flows to try to lock capital into the country. They will also impose price and wage controls to try to stem the inflation.

Of all of these, the most worrying of the possible actions will be the price controls. In particular, it is very likely that they will try to impose controls on the price of food and energy, as the inflation in the price of these items will be the most immediate concern. Price controls, unfortunately, will always result in even greater problems than they are supposed to solve. All you have to do is think of yourself as a dairy farmer, for example and imagine that the government decides that you can not increase the price you charge for milk (sorry, back to milk again).

In this situation, you will see the economy inflating around you, but you will not be able to inflate your milk prices at the same rate. This means that you will be becoming poorer, as the value of the milk you sell will be falling relative to everything else. In this situation, it becomes increasingly pointless to actually continue in the business of selling milk, because you will start to lose money. As a result, the output in your sector will fall, and then there will be shortages.

It is at this point that the situation is completely out of control, with the government imposing ever more 'controls' on ever larger parts of the economy. What happens then, I am not sure...but I do not think it will be a happy situation.

This last section is speculation based upon my best guess of what the government will do. It is also possible that someone will have the courage to lead the government out of its self-created crisis. The answer, of course, is to switch off the printing presses, and accept a period of significant hardship and austerity. However, my speculation is based upon the action of the government to date, in which they have continually sought to pretend that they can control the economy and turn back the clock to the 'good times'.

I have mentioned a couple of times in this blog that I sometime have difficult believing the implication of what I am myself writing. In particular, the rational part of me says 'this is the reality', but the irrational part of me refuses to believe it. Occasionally, such as seeing the article quoted at the start of this post, reality is hammered home. In this case the reality is that the government is now going to try to finance its operations through printing money. This really is the Zimbabwe solution, and however many economists witter on about various justifications, funding a government with printed money is a road to disaster.

The real tragedy of this is that it was completely avoidable. Whatever happened, the UK was going to have to face a very hard time, but there was never any need for it to become as bad as it will become. If the government had shown the courage of leadership, had accepted the underlying reality of the depth of economic problems, it could have set about the essential reform of the UK economy. Instead of this, they chose to delude themselves, and delude the public into thinking that everything could go on as before.

Another tragedy lies in the media. They should be screaming with outrage at what the government is doing, but instead they are wittering about bankers bonuses, and other populist nonsense. They have let themselves be steered away from the reality of exactly what is going on. As I said at the start of the post, the UK government has now effectively declared its bankruptcy, but the headlines in two of the major UK newspapers are 'Archbishop: Christians are seen as mad by society' and 'US agents charge cricket mogul with $8 billion fraud'.

Quite simply, I despair.....

Note 1: I found an interesting article in the Telegraph, in which they report the following:

Last month, the Institute for Fiscal Studies warned that it will take more than 20 years to pay off the debts being run up by the Government during the current crisis.

Calculating that public debt had already risen by £10,000 for every family in the country, the IFS warned of a "tightening" on tax and spending that will have to continue until the early 2030s.

If nothing else, it gives a good sense of scale to the lunacy (italic and bold added by me).

Note 2: In the unlikely event that governments were actually able to meet their insane level of borrowing, just think about the impact of that borrowing on the world economy. For simplicity, we will pretend, for a moment that there is no money printing, and imagine that the total amount of money in the world economy is therefore fixed. If you then were to imagine that the world economy has a total of 1 million units of money, and then think of what governments are doing, the insanity of their actions becomes apparent. Effectively, they taking ever larger slices of that pile of money into their hands for their various stimuli. As such, if the government borrows 500,000 of the total units of money available, then there is 500,000 less available for investment in business. If there is less investment in business, then there is less growth in the world economy.

In the meantime, the 500,000 units of the total is being spent by the government propping up insolvent business (banks, automakers etc.), and being spent in areas that will not create any long term economic growth. In other words, it will be spent on activity which will not solve any problems at all, except in the very short term. By denying this money to private business, they are simply restricting the potential for growth in business overall, and thereby destroy the chances of eventual recovery.

Note 3: Arguments against this post are very welcome. I really would like to believe that I am wrong. If you can convince me I am wrong, I will be genuinely grateful. I really, really do not want to be right.

Note 4: I remember a comment which mentioned that the blog is very popular with farmers. My suggestion to farmers is that they organise and prepare to defend themselves against price controls - have the arguments ready, and if need be, have plans to face down the government. The same for the energy sector. I could be wrong about price controls, as there is no deterministic reason for them, and this is speculating on what actions individuals might decide on. However, bearing in mind that such price controls would devastate your businesses, you may want to take a precautionary approach, and prepare anyway. My best guess is that such controls might appear in about a years time if that is the course that is followed, but that is nothing more than a wild guess.

'Yes' the bankers bear responsibility, but now they are scapegoats..

Before getting on to the main subject, please accept my apologies for the lack of posts recently, but 'real life' sometimes has to take a priority. As I still have demands on my time, a quick post today, and one which is a commentary on news, rather than a particular theme.

Perhaps the most important point I would like to make follows from an article in the Telegraph in which the commentator was discussing a bleak picture for the world economy. He refers to the huge US borrowing needs that are emerging.

Where is the money to come from? China, the Pacific tigers and the commodity powers are no longer amassing foreign reserves ($7.6 trillion). Their exports have collapsed. Instead of buying a trillion dollars of extra bonds each year, they have become net sellers. In aggregate, they dumped $190bn over the last fifteen weeks.

For regular readers, they will remember that I proposed that China would have to start selling US assets to fund their own stimulus, and that in doing so they risked a collapse of the $US. I noted that the Chinese would have to strike a balance in the volume of sales of these assets, such that they pulled in as much value as possible before the whole market collapses, leaving them with piles of useless paper. It looks very much like they are following this course, and the question that therefore looms in my mind is to ask how long before all the other $US holders follow suit?

In the meantime, for those who are probably already spooked in the bond market, the sheer scale of the continuing growth in US government commitments must be rapidly eroding what little confidence there may be left in the $US. On the one hand, Obama's 'stimulus' package looks set to progress through government, and on the other hand there is the latest bailout announcements for the banking system in the US. With each month that passes, the numbers, the massive and horrendous scale of the commitments of the US government, are moving beyond belief.

For those who look at these numbers, they are still comparing these numbers with notional and shrinking measures of GDP. However, for overseas holders of the $US there will be an increasingly frightening question that will by now be crossing their minds. In order for the US to repay this borrowing, at some point they must sell more goods and services than they import, must have a positive current account balance. In order for these monstrous sums of money to be repaid, this means not only reversing a massive trade and current account deficit, but turning these massive deficits into massive surpluses. Quite simply, it is not going to be possible to achieve this if the US government continues the massive borrowing, and attempts to support their economy through ever more borrowing.

In all of the measures, there is not one single measure that addresses fundamental structural reform of the US economy. As such, the holders of $US assets are going to very worried indeed. For those of you who still doubt the potential for a complete $US collapse, I will refer you to a link here, in which it is revealed that there was an electronic run on the US banking system in September, revealed in a C-span broadcast:

At 2 minutes, 20 seconds into this C-Span video clip, Kanjorski reports on a "tremendous draw-down of money market accounts in the United States, to the tune of $550 billion dollars." According to Kanjorski, this electronic transfer occurred over the period of an hour or two

I suggest that watching this will correct any misconceptions that the $US and world economy is not currently in a position of extreme fragility. The really odd thing about this is that the media have not grabbed hold of it yet.

Overall, the process of the unravelling of the $US appears to be going very much as I expected/predicted. The continuing desperate attempts of the US government to support ever larger parts of their economy is just adding fuel to the fire.

Meanwhile, as this is all going on, the world and the media are increasingly distracted with what can only be described as a media circus. The particular circus I am referring to is the question of executive pay, which has served as a handy distraction in which huge numbers of commentators and politicians can indulge in self-righteousness. The reality of the situation is that, whilst the bankers played a part in this crisis, they were not alone, but aided and abetted by government, regulators, and central banks.

However, with their cap in hand for ever more bailout money, one of the prices that the bankers have to pay is to take the full measure of blame on their own shoulders. They are not in a position to point their fingers at the others who have been complicit in the mess that has been created. The price is that blame is doled out to them, and they must bend over and take the beating on behalf of all of those who are responsible. Perhaps one of the more moronic variants in the media can be found in the Telegraph, regarding the enquiry into the crisis. I recommend reading this, if only to illustrate how puerile the whole business has become.

These enquiries also serve a more immediate distraction, which is to shift focus away from why so much money is being poured into an insolvent banking system. This is a matter of importance, not the pay rates of the bankers who are benefiting from the bailout. Whilst their remuneration should be a matter of public concern when they are being bailed out, it is insignificant when compared with the actual bailout overall (over some of my recent posts, I have been building towards a further discussion of the bailouts, but have not yet had the time to address this).

I can not help but think that all of this talk of evil bankers is simply a distraction which serves the politicians by diverting our attention from what really matters, which is that all of their plans and schemes are doing nothing to reverse the current economic crisis, and are already leading to the ultimate collapse of the $US in the case of the US, and £GB in the case of the UK. It only serves to direct all the blame onto a group who are unable to defend themselves, and who are therefore convenient scapegoats.

I will re-emphasise that I am not saying that the bankers did not play a part in the crisis, that they should not be getting large salaries at taxpayers expense, but the way that all of the blame is being heaped upon them is pure scapegoating. This is not a trivial matter, as it means that the others that were responsible for creating the mess are the very same people who are supposed to be resolving the mess, and often with policy that just replicates the original problem in new forms - in other words, the government borrows more as a stand in for the fall in consumer borrowing.

Without the economists, politicians and central bankers taking their blame, they can continue in their positions in which they can continue to cause so much damage.....

Note 1: For those who might mention that Obama is a new pair of hands......take a look at his economic team and policy....

Note 2: A rushed post, so I am sorry that I can not respond to the many good comments on my last post. I will try to catch up....