Krugman and Money Bubbles

In a recent NYT piece, Krugman suggests that 'money is only a “social contrivance”. It’s a convention, which works as long as the future is like the past.' He then goes on to say later:

A final thought: the notion that there must be a “fundamental” source for money’s value, although it’s a right-wing trope, bears a strong family resemblance to the Marxist labor theory of value. In each case what people are missing is that value is an emergent property, not an essence: money, and actually everything, has a market value based on the role it plays in our economy — full stop.

Before reading the rest of the post, you should really read his full discussion, as this post will not make sense without you doing so. For me, the problem is his idea that there is no fundamental source for the value of money. It is wholly fantasy.

Here, for the sake of simplicity, I will treat the following as 'money'; base money (e.g. bits of green paper, and money created by the central bank through open market operations, and debt money (e.g. bonds, bank credit etc.). I know that we could debate the question of differences between these money types, what should be included in money etc. However, my purpose here is specific, and you will (I hope)understand why I characterise money in this way.

For me, the most important thing about money is not about the nature of the money, but about the demands that money might make on the economy. For example, each unit of money is a future demand for x value of product and services in a particular economic unit, typically but not always a country. The interesting thing about money is that it can very broadly be divided into 'now' money, and money in y period of time, or money in y period of time and z now etc. In other words, money units have a temporal dimension. This gives us something of an idea of how money can be seen to be founded in something. This is that the value of money is determined by the demands that might be made on the total value of output in the economic unit.

The important point about this is that, at given moments in time, there is a combination of credit money and base money in any economy. However, at any given moment, there is a total level of output of value in the economy. I use the word value here because what value might be is subjectively derived; for person A, they may value a new television over a Wedgewood tea set, even where the tea set has a higher price. However, regardless of what individuals value, there is a total output, however difficult that might be to measure accurately, but with relative prices making the best proxy that we have for perceptions of value. The point is that, with a given labour force, given technologies, given skill sets, and so forth, there is finite amount of value that can be created in an economy at any given moment.

You will notice here that I am treating an economy as if it is an economic island, which is false. Economies are not islands, and an economy's output is also contingent on the value creation in other economies. For example, if country B makes a product better/more cost effectively (I leave this loose here) than country A, then the country A output of value is questionable unless they do something to match the country B output of value. As such it possible to have potential for output of value that will not be realised, as there is a real world of competition. Therefore, the potential output of value of an economic unit is not its potential, but its potential in relation to other economic units. That potential is continually shifting, dictated by policy, individual and corporate endeavour etc.

The value of money is therefore contingent upon several factors; temporal, quantity, and the potential value of output of the economy which the money represents. For example, the bond market is driven by second guessing the relative influence of these factors, albeit that the second guessing is often crude and misdirected. The key point here is that each monetary unit, given these contingencies, at any given moment in time, represents one x percent of the total value of output in the economy. In other words, money is rooted in the total output of value in the economy, at a given moment in time. There can only be, as an economy is currently structured now, x amount of value of goods/services that can be purchased. I am being simplistic here, as some people simply hold the 'now' money, so that it ceases to be a demand on the economic unit, even though the money exists. In this circumstance, it makes no call on the output of value at that moment. It is another contingency on how money is valued, but by not making a call on the value in the economy now, it allows for a call on value tomorrow. For example, for a bond that has matured, might not be used as money now, but to buy more bonds with a view that this will allow an even greater capture of value in the future.

There are several things that are important when viewing money and value of output in the future. It is quite possible to issue more money now in the expectation that output of value will increase in the future to match the increase in money. Creating a greater supply of money, with the contingency that output of value will match the increase in supply is a risk. If output of value does not increase commensurate to the increase in money, then there is a problem. The value of output per unit of money has diminished. Most damaging of all, is when the demand for the value of output sits outside of the economic unit; if the demand is within the economic, it might represent a transfer, for example the liquidation of a mortgage debt.

However, even then, it is possible that the issuance of too much mortgage 'money' might be inflationary, and problematic. If the mount of money created for mortgages increases faster than the value of the value of the housing stock, this means that there is a specific and narrow price inflation, but also with a wider price inflation in the economy as a whole, as that mortgage money transfers into the economy. It just takes time. The housing bubble was this process in action. The rate of mortgage money creation increased faster than the value of housing stock, and also prompted bubble activity, such as building McMansions as a process of trying to soak up some of this new money creation. This brings me back to the problem of external credit, which is far worse, as it never represents an internal transfer.

The external funding of new money in the economy, such as mortgage debt, is a future external demand on the output of value in the economy. In all cases, it quite literally means that in the future, a demand will be made on the value of output in the economy such that some of that value output will no longer be available within the economic unit. The greater the value of the money created through external debt, the greater the demand on future output of value. This kind of demand can accumulate to the point where the external demands on the total output of value are so large, that an economy has no reasonable chance of servicing the value without having so many goods and services flow out of the economic unit that the actors in the unit will be reduced to penury. This is Greece now.

The curious part of the Greece story is that it is divorced from base money, and the problems are entirely created by creditors realising that the output of the Greek economy is not able to provide the value that they expected, or rather that Greece is unwilling to deliver that value as the loss of that value of output from within the economic unit of Greece is too hard to bear. The external debt of Greece is simply a massive demand on the value of the total output of value of the economic unit called Greece.

The idea that monetary units have no foundation, except in a social construction is simply not true. It is founded in the output of value in the economy for which a particular currency pertains. It may be complex, due to the contingencies that I describe. This is why all debt markets are so complex. However, there is one thing that is certain. If the aggregrate money supply increases faster than the value of output, the value of each unit of money will be diminished. We must also remember that the value of each economic unit is contingent upon the ability of each unit in each area of business, and that the aggregate of the ability will inherently effect the value of money, as this will impact upon the ability to realise potential output of value in an economy. Finally, externally created money is the highest risk, as it will absolutely make a demand on output of value in the future, and that value, if repaid will mean less output of value in the economic unit. Even if the economy does grow in an economic unit, a portion of that growth will no longer be available in the economic unit. The economic unit will have less output of value at the time that the demand is made for the output of value.

The final point is this; expanding money supply without an ability for increases in the output of value destroys the value of money. Borrow and spend is exactly this, and external borrowing is horrendously risky.

Note: This started as a short and quick and 'dirty' post, but did not turn out that way. I hope it all hangs together, and I have avoided some complexity that might have been added due to time constraints, and to keep the ideas as simple as possible. The nature of internally generated debt money is a case in point. Comments, as ever, welcomed. Feel free to be critical and pick holes. I published despite this despite being loose ideas with critiques in mind; I would like to refine these ideas, and critiques (constructive ones) and suggestions will help. In short, I have thrown the ideas 'into the ring' to see how they stand up to critical eyes. Regular readers will know that I have considered money before (sorry, no time to find the link, but it would help in supporting this post), and this is just some further thoughts/evolution/adaptation of the earlier longer and more detailed consideration.

Huh?

This is (as I start writing) intended to be a very short post. I was just browsing through the economics news and found this rather fabulous quote in reference to Spain's shrinking economy:

It is unclear how he can slash the budget deficit from 8.5pc of GDP last year to 5.3pc to meet the compromise target agreed with Brussels after a bruising confrontation.

“It is frankly impossible, given that it would aggravate the recession and this would crush state revenues,” said Jesús Fernández-Villaverde from the University of Pennsylvania.

This is 'fabulous' as it is a very clear illustration of a point I have made several times. It illustrates just how intellectually bankrupt a large swathe of academic economics actually is. I will just start by putting the quote in a usable format:

• Cutting borrowing will make the recession worse
• If the recession is worse, then state revenues will be lowered
• Therefore, if borrowing is cut, state revenues go down
• If state revenues go down, then payment of existing debt becomes impossible

 What this really means is something like this (this is simplified/basic principle only):

• I am borrowing 200 units of new debt per year
• I have to pay 100 units per year from tax revenue to service my existing debt
• The 200 units create activity in the economy as the borrowed money is used for consumption of goods and services
• The activity in the economy from the borrowing of 200 units sees 50 units of the borrowed money returned to me in tax revenue from the tax on the consumption of the 200 units
• If I do not borrow at all, the tax revenue from activity in the economy will only be 50 units
• If I cut borrowing to 100 units I will only see 25 units of tax returned to me from the 100 units borrowed
• Cutting my borrowing to 100 units means that I have the 50 units + 25 units of tax revenue from the borrowing
• If I only receive 75 units I can not pay for my existing debt, which requires 100 units
• Therefore I will continue borrowing 200 units so that I can pay for my existing debt which gives me the 50 units of no borrowing tax revenue + 50 units of tax revenue from the borrowing and consumption of 200 borrowed units
• If I do not borrow 200 units I cannot pay my existing debt.
• If I borrow 200 units, I increase my existing debt.
• If I cannot pay for my existing debt without borrowing, how will I pay for next years greater debt and greater annual servicing costs?

In short, the process is one in which I borrow 'x' amount for others to consume, and then tax that consumption of the borrowed money in order to return a fraction of the debt to me and pretend that this is revenue, not a fraction of the money borrowed earlier. If I do not do so, I can not support my debt. In short, I need to borrow money in order to make payments on previously borrowed money. In doing so, my debt pile gets bigger, necessitating more borrowing to pay previous borrowing. It is an upwards spiral of debt in order to keep paying existing debt. It is also a downwards spiral into greater and ever less sustainable debt. It is a good method of destroying an economy - unless a choice is made to just not pay the debt.

And this is a solution? Really? 

Note: This is a bit of rushed post, but I hope it all makes sense. If there are any errors in the logic, please feel free to point them out. Also, if (and I apologise in advance if I think it is no better) you can offer an even simpler and clearer explanation, I may use it as a post, with full credit to the author (as anonymous, or by name according to your preferences, so let me know). I really think this is one of the most fundamental examples of just plain odd thinking in economics. As such, getting it as clear and logical as possible would be great. I still feel that my explanation is not quite there, or might not quite hang together.

Update, 30 March 2012: A very good explanation from Carrew below, which integrates the fundamental problem of dishonest politicians.TheFatBigot (I really like this name) also weighs in with some good points about GDP and the underlying foundations of revenue, as does MR. Anonymous has picked up on the rather distorting economy as a medical patient metaphor, and proposes a more apt variant. In the case of Carrew and TheFatBigot, they offer some very good explanation. However, although very good, and somewhat simpler, but I am still looking for the 'killer explanation' that skewers this dangerous economic thinking (something which those less interested in economics might grasp with ease). Further efforts would be welcome.
Update, 2nd April 2012: There are some more good thoughts and explanations below.  An anonymous poster has had a good go at it as well. Perhaps between the various comments and my own explanation, someone can provide a good synthesis that takes the good points from all? As ever, I am impressed with the readership of the blog.

Lemming: Apologies, I found a comment from you which escaped the approval process for some reason. I am not sure how long it sat unpublished, but apologies if it was a long time.

Now the US is in Real Trouble - Paulson and Bernanke Succeed

The breaking news in the Times is that the bailout of the US banking system will go ahead. Now, it looks like it is just a matter of detail, and the devil of how bad the decision will be will lie in the detail.

I have noted that, whilst visitor numbers are up, the percentage of returning visitors to the post is not keeping up (though is still high). That possibly means that some of the new visitors who are coming to this blog do not like what they are reading. I suspect that the reason for this is the belief that I am too pessimistic, that they just can not believe that governments can not 'fix' the problems. After all, 'something has to be done'. Government, apparently, can wave a magic wand of debt and fix the stored problems from at least ten years of erroneous financial management. If you reread the last sentence, the absurdity of the idea is self-evident.

Whatever the details, this magic wand will be damaging to the long term prospects of the US economy. When I first saw this crisis, the one thing that was impossible to predict was going to be how individuals would react to it. Whilst thinking that the US would go through some very unpleasant pain, I believed that the US economy would adapt and reinvent itself in light of the new market conditions. My optimism has significantly diminished.

For some reason I have not been discussing some of the hidden negatives in government borrowing. I suggest that you read here before continuing. The point is that government borrowing distorts the economy in more ways than you might imagine, in particular by hoovering up capital, by competing with productive uses of the capital. On top of this, there are the reasons I have outlined in several other posts as follows:

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.

I have mentioned several times why this deal will do harm, even if it gives markets and confidence a lift in the short term. However, again as I have repeated many times, there are more problems in the banking system than just the toxic mortgage debt. The Times report has this to say about Paulson's purpose for the bailout:

'Mr Paulson hopes that once the market recovers, the Treasury will be able to sell the bonds back into the market and recoup taxpayer funds. He is also hoping that once the banks are able to rid themselves of such assets, they will begin lending to one another again and America's capital markets will return to normal.'

There is an assumption here that, if the current bad mortgage debt is cleaned off the books, that will be the end of the crisis. However, such a scenario does not account for the downward spiral of the economy - as it weans itself off consumer credit and house price growth, the drivers of the so called 'service economy'. Whatever is done to bailout the immediate bad mortgage debt, nothing will change the fundamental underlying problems, and those problems are going to reappear in the banking system. As the economy continues to spiral down, there will be a new tranche of mortgage based debt going bad, huge swathes of consumer credit going sour, as well as commercial lending going bad. Will the US government be able to continue with the bailouts? I think not.

A good example of the unwinding can be seen in the UK at the moment, in the troubles of B&B, a UK buy-to-let lender (for US readers, this means providing mortgages, often to private landlords, to rent out property). The Telegraph reports the following:

'Credit Suisse said: "Ultimately, B&B's biggest issue is asset quality and we doubt any major bank will want exposure to a £40bn mortgage portfolio with arrears almost double the industry, and where over 40pc of loans will be in negative equity if house prices fall 30pc peak-to-trough.'

The interesting point here is that B&B is particularly heavily exposed to a high risk part of the market, and they are therefore acting as a weathervane. Mortgage and consumer credit arrears are up (see here and here - both out of date so the situation will be far worse now), and will get far worse as unemployment climbs. This applies equally to the US and UK. The arrears are increasingly going to spread into what was seen as the safe lending, or the lending to those who were in employment and could previously manage their payments. Under normal circumstances, this would be a problem but would be a manageble problem. However, with balance sheets already in tatters, this becomes another crisis. The trouble is that the debt bubble has hidden the underlying weakness of the economy, and the banks have been acting and lending on a belief that the economy was strong. That has been a fatal miscalculation, and nothing can soak up the sheer scale of bad lending.

So will all of the financial institutions suddenly start lending to one another again? The answer is that they will continue to hoard capital, as they will be aware that they will need the capital to offset the losses in the coming months/year. The bailout will give them a breathing space, will prolong the life of the weaker institutions, but nothing can stop the ongoing losses and the next tranche of failures.

So what will this bailout, this 'doing something', achieve? It will just act to hobble the US economy, and at best delay the progess of the crisis without stopping it. It will buy time, but at the cost of the future speed of recovery of the US economy. The only upside will be that it will speed the devaluation of the $US, which will allow the US economy to become more competitive, albeit at the cost of the relative impoverishment that this implies.

It is not a good day for the US economy, and that also means that it is not a good day for the world economy.

Note: In some of my previous posts I have been discussing that the emerging market currencies will increase in value compared with those of the West ($US, Euro, £GB). I have neglected to mention that the same might be said of the big commodity producers. An interesting question will be whether the currencies that are pegged to the $US will free their currencies? My guess is that it will only be a matter of time, and I have noted others have a similar opinion (sorry, no refernces to hand on this point, as this note is a rushed afterthought).

Note 2: I recently discussed a report that was pessimistic about China, and have just found a new report that is far more positive about the prospects for China. As I keep saying, China is very opaque, and this means that it is a 'wildcard'. Even with $US devaluation they have significant resources available to carry them through the downturn, but will it be enough. See my post here for a discussion a discussion of why China is a question mark.

Note 3: Some time ago, I promised that I would write a further post on reform (in this case regulation), but have not managed to do this. The current events have been a bit of a distraction and I hope to return to reform in the future, as this is one of the main purposes of this blog. It is all very well to consider the problems, but what is really needed is solutions.

Note 4: I have found this in the Telegraph:

'Meanwhile, ratings agency Fitch said the vast bail-outs agreed yesterday by the US Congress do not add significantly to America’s public debt of 57pc of GDP since the money is being used to buy assets, which are backed by collateral. '

So let's get this clear. Nobody wants to buy this toxic waste, not even the sovereign wealth funds, even though the debt is available at firesale prices. Despite this, apparently the is backed by collateral, even though the collateral becomes worth less with every day that goes by. It is a bit like securing a loan against a burning building - fine if someone can put the fire out, but otherwise not really much use.

Final Note: I thought perhaps some light relief is in order; this from the Spectator:

'If you had purchased £1000 of Northern Rock shares one year ago it would now be worth £4.95. With HBOS, earlier this week your £1000 would have been worth £16.50, £1000 invested in XL Leisure would now be worth less than £5, but if you bought £1000 worth of Tennents Lager one year ago, drank it all, then took the empty cans to an aluminium re-cycling plant, you would get £214. So based on the above statistics the best current investment advice is to drink heavily and recycle.'

In current circumstances, this might be a popular investment tip......

Recessions are Hard to Predict?

An interesting article has appeared in The Telegraph in which they discuss the difficulty of predicting recessions.

The interesting part of the article is as follows:

'Meanwhile, growth in consumer spending, which has been the engine for UK growth for most of the past decade, slowed appreciably - though the precise data on this will not be available until next month.'

In writing this, they neatly sum up why economists were unable to predict the current slide into recession and depression. Once again, they are conflating consumer spending with economic growth, without actually considering where the consumer spending originates. In doing so, they are making the fundamental error of mistaking growth in debt with economic growth. This was one of the central themes of 'A Funny View of Wealth' and I still look on in wonder as I watch how mainstream economists continue to make this fundamental error in the face of the looming economic crisis.

At what point will they finally understand that measuring economic growth on the basis of consumer activity is a recipe for economic disaster?

The Telegraph goes on to say the following:

'Such a suspicion is confirmed by the ONS numbers, although there were a few surprises. Most notably, the services sector, which accounts for around three quarters of UK economic growth, expanded slightly faster than in the first quarter.

However, a closer look shows that this was largely thanks to a surge in transport and communication - perhaps in part due to higher petrol prices boosting profits.

The National Institute for Economic and Social Research said in its latest quarterly report that Britain faces three years of anaemic economic growth, though it will avoid a recession.

I happen to believe that it is too optimistic. With UK consumers and companies more indebted than any of their counterparts overseas the scale of the economic slowdown facing us will be significant.

Don't forget that only a few months ago a variety of economists (and the Council of Mortgage Lenders comes to mind here) were confidently predicting that house prices would not fall this year.

They could not have been more completely, utterly wrong. Economists find it hard to forecast recessions.'

The really curious part is that the author of this article 'sort of gets it', but just does not quite manage to grasp the central point. There is the recognition of the debt problem but no connection is made with the illusory growth that was created by the debt.

I get the feeling that mainstream economists are finally on the cusp of discovery, and am now waiting patiently for the reality to sink in. At that point, no doubt, everyone will become wise with hindsight, and discover what readers of this blog have known for a long time:

Consumer spending does not mean economic growth.

What of the UK?

I have had another comment from Dan, who has posted the following questions:

'To get back to my original point, what does the author see Britain being like in one year from now? Would we recognise it as the country we know today? Or will it be a very different place, where many of the rights and absolutes we take for granted no longer exist? Are we heading for the 2nd, or even 3rd world? I feel that the author still is shying away from telling us how this is all going to end. I can understand any reluctance to do this, because it really is going to be that bad. Social disorder on an unimaginable scale.'

The first point is that this blog's purpose is to try to examine economics, rather than social consequences (though they are interlinked to some degree). As such, I will not deal with these aspects of Dan's comment.

If I answer the 'years time' question there are several certainties - but also uncertainties. The reason why it was possible to predict the current crisis was that there was a stability in the policy and economic activity that was clearly leading to the current crisis. It was very clear that no one would change direction, or that anything would/could occur to deflect the inevitable crisis.
I have already written here that there will likely be some bank failures as the second credit crisis bites. This second crisis will lag the rise in unemployment and company bankruptcies. I have also suggested that there will be a major crisis in government funding as government revenue plunges, and expenditure climbs. What we then have is a series of crises, and the trouble is that, in a crisis, it is not always obvious how individuals will react. Will individuals accept the real reason for the crisis, or will they continue on the same assumptions that created the problems in the first place?

There are already voices suggesting that the solution to the problems lies in more state spending. For example, Will Hutton suggests in the Guardian a Keynesian economic boost to the economy - using borrowing and spend as a way out of the crisis. However, even assuming that is the solution adopted by the government, it is very unlikely that the government would gain funding for such a 'boost'.

For the moment it is worth considering this idea, as it will certainly gain support in the coming months. I am personally of the view that this kind of Keynesian (neo-Keynesian) policy would be absolutely wrong under nearly all circumstances. However, for the moment we will pretend that we agree in principle. Even if we do this we face some serious problems, as one of the foundations of the idea is that we pay off debt in the 'good times' and spend in the 'bad times'. If we look at the last ten years, we see that national indebtedness has increased in every part of the economy, including the government. As such, this kind of policy just becomes a fig leaf for just running up more debt. There would be no real justification for it. Picking a Keynesian solution at this stage in the cycle, having already increased borrowing, is just being dishonest - you can not just jump into this solution at your convenience. Either you follow it 100%, or you do not follow it.

(as a note, you may want to see here for the 2007 levels of debt in the UK and here for a discussion of the debt from another blogger)

The point in bringing this up is that it is quite probable that this will be one of the proposed solutions to the coming crisis. It is just another economic dead end and, if the government goes down this route, then the crisis can only be magnified. As I have said, how individuals react to the crisis will be what determines the future, and there are many options open to the government. Some options will accelerate the crisis, others will ameliorate it.

If we add to this the rather odd idea of 'sentiment', then life gets even more complicated. I have predicted a loss of confidence in the UK economy, and that this will likely lead to the government going to the IMF for a bail-out. This is just one element of sentiment. What individuals in government do will, for better or worse, effect sentiment inside and outside the UK. If individuals lose confidence in the government's solution to the crisis, then sentiment will be negative, and the spiral down will accelerate.

These are the unknowns in the current situation, which will determine how bad things will become. There are still some certainties that mean, whatever course of action is followed, the situation is going to get much worse before it gets better. These circumstances I have detailed elsewhere.

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. The real question is whether the changes will be put in place for recovery, and whether the government will take the tough decisions necessary to create a future stabilisation. The big question that this raises is how might this be done?

One element of change is already taking place - the fall in the £GB is one of the solutions, but the fall in the pound comes at the cost of the country becoming poorer (as I have detailed elsewhere). At some point, the UK needs to take positive steps to improve the economy. These are the long term and tough solutions.

I have already addressed one of the fundamental issues, which the UK government can not handle alone. That is the question of how to deal with the rise of China, such that it starts to trade fairly. The second question is how the UK can adapt to a world in which we now have to face the competitive threat that China presents, and how we can win against such a threat. This is a question that I hope to deal with in the coming weeks.

It will mean that the UK will have to make some major changes in the way that the economy is structured. Part of that will be for the role of the state in the economy to shrink, and part of it will be wholesale reform of many institutions, such that the UK can become prepared for a tougher world. None of these are quick fixes. The economy has to sink back a long way before it can even start to stabilise, and that process will continue for at least two years, but maybe much longer, in particular if the government ignores the fundamental problems, and continues down the path that led the UK into this mess. Of note is that there is no avoiding the debt hangover, and this will be an ongoing drag on the economy for many years to come. Can reform be made to ameliorate the effects of the debt hangover - 'yes' - but many of the problems are structural and will take many years to resolve.

As soon as I have time, I will start with my solution to just one of the keys to economic success - an effective education system. It is the kind of reform that will only start to bear fruit in 5-10 years time, but needs to be started immediately. Education lays the foundations of future success, but the education must be of a high standard, and must see the major investment required produce real quality, not the ersatz quality that has become the norm.

To return to Dan's question, will we recognise the UK one year from now? The answer is that, whatever happens, the UK will look to be a much poorer place, though it will be too soon for this to deeply effect the institutional structures of the UK. In some respects the UK will look much as it does now, just a poorer and very depressed version. The real question mark will be whether there will be the preparations for a real long term recovery, or a continuation towards decline and eventual stagnation and irrelevance. Will the reform of institutions and structures of the UK be starting, or will there just be inertia such that the institutions simply wither, along with the UK and UK economy? As I have said, the answers to these questions lie in the hands of individuals, and the decisions they take.

The wake up starts

In my essay, 'A Funny View of Wealth', I highlighted the fact that the UK economy was built not on real growth of productive wealth, but was built upon a foundation of debt and immigration (written in October/November last year, sent to Boris Johnson at that time, only recently published here). My point was that this was unsustainable and was economic madness. The UK appeared to have a growing economy, and economists were treating the growth in debt as wealth creation. See the following link for the full argument (it is a lengthy essay, I'm afraid).

http://cynicuseconomicus.blogspot.com/2008/06/funny-view-of-wealth.html

It now seems that, as ever, the economists are waking up to the reality of the situation too late. This is a quote from the Telegraph:

'British households are now more indebted than those of any other major country in recorded history, it has emerged.

Families in the UK now owe a record 173pc of their incomes in debts, official figures have shown. The ratio of debt to income is higher than any other country in the Group of Seven leading industrialised economies, and is sharply higher than the 129pc of incomes it was five years ago.'

And:

'Economists warned that the combination of data, which also included news of the saving ratio dropping to the lowest level since 1959 and of household disposable incomes falling at the fastest rate since 1999, suggested Britain is heading for a sharper downturn than many had anticipated.'

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/06/28/cndebt128.xml

I have tried to find a neat quote from 'A Funny View of Wealth' but the nearest I can come is the following:

'The UK has been seen as a stable and expanding economy, an economic success, and this belief has attracted the inflows of money available for lending. The problem here is that it is the inflow of cheap money that has supported debt accumulation by consumers, and this in turn has made the economy appear so successful.'

I strongly recommend you read the full article, as it explains the position more clearly. I could fine no single quote to illustrate how this was all so predictable, but all the elements are included in the essay.

So here we are, when it is all too late, the economists have finally managed to grasp that high levels of debt do not a strong economy make. However, they have still not managed to link this growth in debt to the supposed 'growth' in the UK economy. It is at times like this that my frustration bubbles up, an I have an urge to yell at the economists who are supposed to be the experts. How on earth do they manage to miss this simple point? In the unlikely event that any economists pull their heads out of their charts, this is my simple message to them:

MEASURE THE GDP GROWTH IN TERMS OF £ sterling, SUBTRACT THE GROWTH RESULTANT FROM TEMPORARY IMMIGRATION, SUBTRACT THE AMOUNT OF CONSUMER CREDIT GROWTH, SUBTRACT THE MORTGAGE EQUITY WITHDRAWAL, SUBTRACT THE GOVERNMENT BORROWING, AND RECALCULATE REAL GDP GROWTH.

Sorry for the caps, but it is the only way that I can express my frustration. In other words measure real growth in UK output in terms of real SUSTAINABLE wealth generated. There are, of course, other factors that need to be considered such as the exchange rate and inflation, but the principle is clear. Real growth is not the same as growth in debt, or growth as a result of temporary immigration.

The point is to ask; has the UK become richer over the last ten years? According to the idea that increase in economic activity equates to a real increase in wealth, 'yes'. According to the idea that increases in economic activity due to temporary immigration and growth in debt, 'no'. How simple is that? As soon as you strip out debt and immigration, you will find that the UK is no richer than 10 years ago, it just looks richer. In fact, it is much poorer, as all the debt now needs to be repaid.

I am massively simplifying here, and losing some key points (and better explanations) through the simplification. If what I am saying strikes a chord, take the time to read the full essay.

The Telegraph report also said the following:

'Market researcher GfK said its consumer confidence barometer dropped five points this month to -34 points - the lowest since 1990, when the worsening economy contributed to the downfall of Margaret Thatcher. GfK warned that the measure is now only a point away from hitting its lowest ebb since comparable records began in 1974.'

I would point you to the following section in my essay:

'These layoffs will commence from a trickle at the end of January and will rapidly accelerate to a deluge in the following months. Consumer sentiment will drop to all time lows. Credit defaults will start to rise rapidly, with the rise in defaults lagging the downturn by about 3 months.'

The drop in consumer confidence is 100% right. The layoffs were slightly slower to start than I predicted, but I hope that being about 2 months wrong will be forgiven. The deluge is starting now. Wait for the employment figures for May/June/July. Unemployment is already rising, and the deluge will follow.

On a related subject, there is also a report in the Telegraph that it will be many, many years before house prices return to their recent peaks. Once again, the economists are waking up to reality. The rate at which house prices decrease is now accelerating. My prediction in 'A Funny View of Wealth' was as follows:

'The slow fall in house prices will accelerate into a full blown crash, with February or March being the months where the falls really start to accelerate. In the six months that follow prices will drop by an average of 20 - 25%, as buy to letters panic and sell into a falling market. In part this will be a response to the fall in house prices, in part it will be due to increasing difficulty in renting their properties (though this factor will lag the price drop).'

I am starting to think that this was conservative. I went on to say that:

'After about six months the rate of the fall in house prices will decline, as some individuals start to imagine that house prices are now at the bottom. They will, unfortunately, be mistaken. Prices will continue to drop a further 20% over a period of a further year, at which time they will bottom out and stagnate for another one to two years. The real fall in house prices will be over 45% during the period of economic contraction (the IMF estimates an overvaluation of 40% and the drop will overshoot this).'

I am now thinking that this may be conservative too. Perhaps as much as 60% will be closer to the mark.

As ever, an apology for so much gloom and, as ever, I am just reporting it as I see it.