Showing posts with label government debt. Show all posts
Showing posts with label government debt. Show all posts

Tuesday, November 20, 2012

France Downgraded

For regular readers, they will know that I do not have much (any?) respect for the ratings agencies, but will also recognise that their pronouncements have impact. When they pronounce, the world listens, and in the case of the banks, they must listen due to capital adequacy regulations. This is from Reuters:

France lost its prized triple-A badge from the Standard & Poor's in January and so Monday's move by Moody's was not surprising but it underlined doubts about Socialist President Francois Hollande's ability to fix France's public finances.
This is a commentary from the same article:
"I don't expect it (the downgrade) to have an immediate knock-on impact today on access to and cost of funding," said Espirito Santo analyst Andrew Lim of the possible impact on the banking sector. "But it's symptomatic of the wider concerns of a plain-vanilla negative impact on the economy being suffered in the next few months and quarters. Spain, Italy and peripheral Europe are weakening and France's exposure to them is something to be aware of."
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM
Whilst the Euro sank a little, it is not seen as a harbinger of crisis, or at least not yet. Another article notes some of the upcoming risks:

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.
It is a very good point. When those doing the bailouts look less creditworthy, there are the makings of a future crisis. This from the Wall Street Journal:

The European Financial Stability Facility is widely expected to receive a credit rating downgrade within the week, allowing it to resurrect plans to issue bonds after the rescue fund's second-biggest backer--France--saw its rating trimmed.

A downgrade could marginally curb demand for EFSF debt. It would normally make it harder for borrowers to raise funds. But for the EFSF, it would help resume plans to finish its 2012 funding program after it was forced to shelve a three-year bond sale Tuesday due to the rating discrepancy between the EFSF and France.

The EFSF--Europe's short-term bailout fund that has helped raise cash for Greece, Ireland and Portugal--said Monday that it planned to sell three-year bonds denominated in euros.But the decision later in the day from Moody's Investors Service Inc. to strip France of its triple-A rating complicated the proposed EFSF deal, as it left the rescue fund's rating standing above that of one of its key backers. The EFSF described the decision to shelve the deal as "technical." Under its so-called Deeds of Guarantee rules, it was forced to pull it despite having attracted more than 3 billion euros ($3.8 billion) in investor demand.
A piece in the Australian is highly critical of the (relatively) new French President, Francois Hollande (in some respects, a rather silly piece describing how he is enjoying the perks of power, but also with some more serious material):

Unfortunately, economic indicators suggest otherwise: unless it acts fast, "la belle France", for all its fine talk could become the latest and most significant victim of the eurozone debt crisis.

Economist Nicolas Baverez was one of the first to predict France's downfall a decade ago. He argued last week that the President, whose popularity has plummeted faster than that of any of his predecessors since his election in May, is in denial of the financial tsunami that could batter his palace walls by next year.

"He has missed at least three opportunities to begin a recovery," said Mr Baverez, warning that unless Mr Hollande quickly implemented reforms, the country would face the humiliation of being forced to go cap in hand to the eurozone and the International Monetary Fund for a bailout.

"In 2013 our country will be the world's biggest borrower of euros, bringing recession, soaring unemployment and an inevitable financial crisis," said Mr Baverez. "Germany will make France pay dearly for its backing."

[and later]

As thousands of people marched through the streets of Paris last week as part of a pan-European protest against austerity, student Laurent Botti, 21, handed out leaflets accusing Mr Hollande of being a "clone" of the conservative Mr Sarkozy.

"He has betrayed us," Mr Botti said, complaining that Mr Hollande had presented himself in the election as Europe's anti-austerity champion but had ended up siding with "big business".

Whatever the case, something has to be done, quickly: public spending accounts for more than half of French GDP, the highest share in the eurozone. No government has balanced the budget since 1981, thus public debt has risen from 22 per cent in those days to more than 90 per cent. The economy is stagnant and will hardly grow next year. More than 10 per cent of the workforce - and close to a quarter of the young - are without work.
This story has a particularly interesting aspect. Hollande campaigned on an anti-austerity ticket, and is now confronted with the power of the bond markets to discipline perceived high risk states. I found this an interesting story in light of a very thoughtful piece in Spiegel recently (I have growing respect for this publication, as one of the few outlets that offers real depth of analysis). This particular point came to mind when seeing the French downgrade:

The attempt by countries to bolster the faltering financial system has in fact increased their dependency on the financial markets to such an extent that their policies are now shaped by two sovereigns: the people and creditors. Creditors and investors demand debt reduction and the prospect of growth, while the people, who want work and prosperity, are noticing that their politicians are now paying more attention to creditors. The power of the street is no match for the power of interest. As a result, the financial crisis has turned into a crisis of democracy, one that can become much more existential than any financial crisis.
I have long railed against government debt, and continue to wonder why governments in mature economies need to borrow at all. The Spiegel analysis is quite correct. Democracy, and the belief in democracy is now on the chopping block. We can see this most clearly in the countries that are already going through the most severe crises, such as Greece.

The problem that we, meaning all of the electorates of the Western democracies (to varying degrees) face, is our own immaturity. Whilst some of the democracies are very mature in terms of age, the behaviour of the electorate remains immature. When we see protesters on the streets of Europe, protesting against austerity, we have a picture that is analogous to the teenager having a tantrum and demanding a new iPad. The fact that his parents are already in debt, and cannot afford the iPad is entirely absent from his thoughts.

In the case of Francois Hollande, he promised the goods and the French electorate duly elected him. However, when coming to power and facing the reality of France's economic situation, he is now being forced to backtrack. The result is that his popularity is plummeting (sorry, cannot find the link for this). The problem faced by Francois Hollande is the problem faced in so many countries. The electorate demand a standard of living that is higher than can be funded from the output of the economy. To return to the article in the Australian:

The figures tell only part of the story. A report commissioned by Mr Hollande from Louis Gallois, a respected business leader, blamed the eurozone's heaviest social charges on payrolls, over-regulation and exceptionally high taxes for undermining France's competitiveness.

Genevieve Forestier, who abandoned her dream to set up a fashion label last year to take a job in a lawyer's office instead, could not agree more. "All the social charges and taxes are enough to put off even the most enthusiastic of entrepreneurs," she said. "The worst thing, though, about running your own business in France is that once you've hired someone it is virtually impossible to fire them. I've heard of a case where an employer had to continue paying a worker's salary even though he was in prison."

Not surprisingly, new firms seldom get off the ground and France has fewer small and medium-sized companies than Germany, Italy or Britain. At the same time the government continues living beyond its means. Mr Hollande agrees that the state should spend less, but some of the cuts thus far seem cosmetic.

The prospect of France losing market confidence terrifies European Union officials. It might need a bailout on such a scale that the mechanism to preserve the euro would be overwhelmed.
It is a crude piece of commentary, but nevertheless captures some of the problems being faced by France. As France has lost competitiveness, the debt has been increasing. This is the story that sits underneath the economic crisis. The immaturity of demanding 'x' standard of living in economies that can only really afford 'x-' standard of living. Even as the emerging economies were rising in competition with the mature economies, the demands for ever higher standards of living increased. It was the role of governments, whatever it might take, to deliver these ever higher standards. This from the Spiegel article:

When the debts of companies and private households are added to the public debt, the sum of all debt has grown at twice the rate of economic output since 1985, and it is now three times the size of the gross world product. Economies in the developed world would appear to require credit-financed demand in order to continue growing -- they need consumers, companies and governments to go into debt and to put off paying for their demand until some unspecified point in the future. Of its own accord, this economic system produces the compulsion to drive up the debt of public and private households.

Governments delegate power and creative force to the markets, in the hope of reaping growth and employment, thereby expanding the financial latitude of policymakers. Government budgets that were built on debt continued to create the illusion of power, until the markets exerted their power through interest.

Interest spending is now the third-largest item in Germany's federal budget, and one in three German municipalities is no longer able to amortize its debt on its own. In the United States, the national debt has grown in the last four years from $10 trillion to more than $16 trillion, as more and more municipalities file for bankruptcy. In Greece, Spain and Italy, the bond markets now indirectly affect pensions, positions provided for in budgets and wages.
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM
The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM

The stronger news is that the EFSF and ESM ratings may suffer with the French downgrade. Also, French corporates and banks may be subject to downgrades following the sovereign action as well.

"We do note that downgrades are warranted as our own sovereign ratings model shows France's implied ratings at AA/Aa2/AA, which remain below actual ratings of AA+/Aa1/AAA", wrote the BBH team of analysts, seeing scope for more downgrades given what we see as major misalignments in its ratings, especially with Fitch now.

Read more: http://community.nasdaq.com/News/2012-11/france-rating-downgrade-threatens-efsf-and-esm-bbh.aspx?storyid=191416#ixzz2Cn4QcAbM
One of the notable points is about household debt. We can see the mentality that is driving the electorate, which is in turn driving the politicians, by visiting an electrical store. Why pay now when you can pay later? We know that the people who enter the store, with a tight household budget already, deep down know that the purchase of the latest shiny good is going to put their overall budget at risk. However, they still buy. They just want that shiny new good. This is the mentality of the electorate, and it is no surprise that we get politicians who pander to this immaturity. There is a fundamental lack of maturity, and self-justification is given for poor budget choices.

As such, when the politicians, economists, and policy makers seek to justify yet further increases in debt, they are pushing at open doors of an immature electorate. We, the electorate grasp at their justifications willingly, as they are telling us that they can 'magic' into existence the shiny goods that we desire. And, as if by magic, they seem to keep on making them appear. However, it is just another variant of the electrical store offering 'buy now, pay later'. The Spiegel article understands the point. It subtitles the article 'betting with trillions'. The principle is this; increase the borrowing to solve the problem of previous borrowing. It is perhaps the greatest wager ever made. It is a wager that might collapse the global economy. We, the electorate, are collectively urging them to raise the stakes.

Saturday, October 20, 2012

The UK: Statistics and Economy

Some time ago, I was complaining about the increasing opacity/difficulty in obtaining information about the UK economy, for example with the previously wonderful National Statistics now completely hopeless. As such, I have to offer a big word of thanks to Dr. Tim Morgan of Tullett Prebon, who has made an excellent database of statistics available here, and would also recommend the database to those who are likewise frustrated with finding basic data from the official sites. In practical terms, it means less time looking for information, and more time looking at what the data might mean. This is what Dr. Morgan has to say:

Finding key data on UK issues such as inflation, the economy, spending, taxation and debt can all too often prove time-consuming and baffling. The Tullett Prebon UK Economic & Fiscal Database is designed to contribute to the quality of the public debate by providing all participants with ready access to objective and consistent data.

As a celebration of so much easily accessible information, I will today overload on statistics, and use the statistics as a foundation for a review of the UK economy. First of all the government finances, commencing with a breakdown of revenues (billions):


There are a couple of points of note here; the first is that after the drop that took place when the economic crisis became visible, revenue has been steadily increasing with VAT revenue growth particularly pronounced. A commentator recently suggested that the deficit growth was due to a collapse in revenue, but we can see that this only explains a small element of the deficit. With regards to collecting revenues, I propose a more open, efficient and transparent system, and a system that will also reduce costs and distortions in behaviour. For example, I propose the abolition of all corporation tax, and a flat income tax. Since writing the post on reform, I have identified some problems with the proposal, but still hold with the principles (I may update the post if I have some time).

Below, we have spending (£billions):


I don't think any reader of this blog will be unaware of the growing problems of financing pensions and health with an ageing population. I have often spoken about the necessity of priority; that the government needs to make some hard choices between where an ultimately limited amount of resource might go. I have also argued that there are ways of cutting the expenditure of government whilst also maintaining provision of services and safety nets. For example, as one of the more controversial suggestions, I propose that welfare becomes an interest free loan with a finite duration and amount. It is a system that would see the welfare share of spending fall, albeit that it would increase government borrowing in the short term. It is a return to the principle of welfare; that it is a safety net. If you look at the links at the top right of the page, you will find solutions to some other areas of spending. I chose the area chart format as they give a good picture of direction of spending and income, but the overview is better represented through a bar chart (billions, at current values):



It does not look very pretty overall. In fact, it look downright ugly. We then have to ask what this is achieving. How is the UK economy really doing? This is unemployment during massive credit expansion:



In this figure, we can see the impact of the boom, and the appearance of the economic crisis is vivid. When looking at the chart, when looking at the fall in unemployment, it needs to be considered in relation to debt, both government (see above) and private:



It is very apparent that debt growth was masking underlying problems in the UK economy. The second chart perhaps is more scary than it should be. We need to remember that the massive increase in aggregate debt took place during a period of high immigration; the massive expansion of borrowing and the activity that it generated had less impact upon unemployment as it also coincided with high immigration levels. This is from the ONS:


And this reflects in the number in employment:

In these charts, we can see that the rapid credit expansion did dent the unemployment statistics as much as would be expected, as the size of the workforce was also increasing, with significant immigration accompanying the credit boom. The really interesting part is to see what all of these people were actually doing:

Perhaps the most notable point in this, is the increasing size of financial intermediation. Although the figures only go to to 2010, we can see the expansion and subsequent contraction of areas that would be associated with a credit boom; wholesale and retail, real estate. Somewhat surprising is that hotel and restaurants did not see greater expansion. Financial intermediation by contrast, has grown and grown, and (at least as far as these figures go) has not yet started to contract, but I believe that this is now taking place from various news stories (and see below). I took a look at the 2007 SIC codes, to get some sense of what the high expansion in 'all other' means, and examples include legal and accounting, management consultancy, scientific research, R&D, Market Research, rental and leasing of machinery, recruitment consultancy, security services, administrative support services etc. In other words, some of these activities might be associated closely with credit expansion, and other not. Manufacturing is notably flat, as are the primary commodity sectors. Although the chart given above is helpful, it does not give an indication of actual employment, and I dug out some figures from ONS, and created the following (key is given underneath):


A = Agriculture, forestry & fishing, B = Mining and Quarrying, C = Manufacturing, D = Electricity, gas, steam & air conditioning supply, E = Water supply, sewerage etc., F = Construction, G = Wholesale, retail, motor trades, H = Transport and Storage, I = Accommodation and food, J = Information and Communication, K = Financial and Insurance, L = Real Estate, M = Professional and Technical Services, N = Admin and Support Services, O = Public admin, defence and compulsory social security, P = Education, Q = Human Health and social work, R = Arts, entertainment and rec, S = All other services.

The stand outs are the decline in manufacturing employment, Construction, Real Estate, and Retail, albeit that there is something of an uptick in the latter. Also notable is that the numbers working for the state appears to be in decline, but we need to consider this against the increase in 'All other' in the earlier chart of GVA and the increase in Professional Services in this chart; it may be that there is displacement going on here..... Another stand out is the increase in Q, Human Health and Social Work, which now seems to be reversing. A real curiosity is the growth in in D & E, which covers utilities; for E this can be explained by the rejuvenation of infrastructure being undertaken by the water companies (as a guess), but the increase in numbers for electricity is more of a puzzle. As discussed earlier, finance and insurance sees the numbers reducing, which is not apparent in the GVA chart. However, whilst this paints a picture of the post economic crisis, more interesting is to look at what has taken place whilst the world economy restructured in response to the entry of the emerging economies into the system, so I have added December 2000 to the chart, with the label of 'Series 6'. I have placed it next to the 2011 figures to make the changes more apparent.


Manufacturing is startling, even though we have long known this to be the case. For construction, there is still have a way to go before reaching pre-boom numbers, and any reversal of credit growth will mean this sector will shrink even further than pre-boom numbers. If we look at retail now in comparison with unsecured debt now and in 2000 (see earlier chart), the picture is mixed. In contrast to the more recent picture, accommodation and food, however, appears to be an area that may have some contraction if credit growth slows, but there is a question of whether people will forgo retail to continue to enjoy these services, which is a different question, and might mean contraction in retail. In other words, how will disposable income be split between these two sectors if credit expansion stops. Real estate activities still seems to over-large in numbers employed, and still has a way to go down. An offset here is that there are reports of inwards investment into UK real estate, with buyers considering the UK a safe haven. In other words, the sector may yet have 'legs', but my guess is that it is unlikely to last too long.

I have already discussed professional services, and the picture here may be seen as supporting the point about displacement (also see N, Admin support, which may be the same question). However, when looking at export figures, these services appear to have grown, so it is hard to make sense of the figures when aggregated. Education (P) is a real standout for growth in employment. It would be interesting to see how much of this growth is in the tertiary sector, which would reflect the government goals of expanding tertiary education, and also the increase in numbers of overseas students. Whether overseas students will continue to want a UK education is a question that is debatable, as questions are being raised about educational quality (beyond the scope of this post). Finally, we come to another huge standout; health (Q). This stands as an exemplar of the hard choices being confronted by government. In simple terms, each additional person employed in the health system is one less person with potential to be employed in underlying wealth generating activity in the wider economy. And the numbers are going to keep on growing as the population ages. Much more could be said on this subject, but I will leave this open for the moment (at risk of comments that point out that it is not as simple point as I make it). 

 We now come to wages. Below are some key figures for wages and inflation:



I have titled the chart 'getting poorer', as this is the picture it paints. You need to consider this in light of the ongoing massive borrow and spend of government, and the dubious activity of printing money. Also, you need to consider that the indices for inflation are questionable, and that even if accepting the indices in principle, the impact upon individual households is variable. If we really want to understand something about the underlying nature of the economy, the devil is in the detail (sorry for the messy chart, but it is readable). I have gone a bit further back than the chart above, and this is because of the fascinating story of consumer durables.

You will note how there was significant deflation in the price of consumer durables, which we can safely say reflects the entry of countries like China into the world economy. We can see the peaks in energy prices, and the fall in the same prices as the economic crisis bit home. And now, we see inflation in energy once again; however, this time, the inflation may yet be offset as the global economy teeters (in part driven by higher energy prices), in part by the adoption of fracking. On the other sideof the coin, so called 'green energy' are a potential driver in the UK towards higher electricity prices. The chart below gives annual electricity bills, and it is apparent that they are growing rapidly. It deserves a post in its own right, but there are considerable problems looming for UK electricity supply, and the real cost of 'green' energy is now becoming apparent in Germany (e.g. see here and here)



Higher energy prices, it should be remembered, impact more upon those with lower incomes, and the same can be said of food prices. Income spent on energy is not spent elsewhere. The final point of note is that consumer durables have now started to climb in price. If  we look at the $US exchange rate, which is the currency of trade, we can see something of the reason (£GB - $US).


Other factors that may also having an impact are rising wages in places like China, and rising energy prices. However, if China does slow significantly, it is quite possible that there will again be deflation in consumer durables; as orders in Chinese factories decline, there may be a period of significant discounting as businesses seek to at least contribute something to their fixed costs. However, the trajectory of the £GB may offset this, and there is ongoing money printing policies in the major economies to muddle any idea of future exchange rates. Competitive devaluation through printing money means that UK money printing effects may be neutralised by other countries printing money. In summary, inflation is very likely to continue, but the degree of future inflation is a very open question. There are simply too many variables that might impact upon inflation in the UK, with UK government and central bank policy simply additional influences.

With regards to house prices, they continue to fall in price in inflation adjusted terms, even if headline prices are relatively stable:

More interesting is the house price to earnings ratio, given below:

By historical standards, they are still high. I must however mention that house prices are, in part, being supported by the inwards investment, as discussed earlier, in particular in London. Nevertheless, the current ratio suggests current prices are not as stable as they may appear. The Economist also proposes that UK real estate is overvalued compared with rental value (26%) and income (17%), suggesting that real declines will continue at some stage.

My final chart of the day is one I will copy from a previous post, covers the balance of trade, and comes from the (from ONS):

£billion, seasonally adjusted
As I stated in a recent post, it is a good indicator of the long term sustainability of the standard of living within an economy and, again, it is not a very positive picture. 

So how can we add up all of these piles of charts? The first point I would like to make is that we can, in part, see that the economic crisis did NOT start in 2008, but started much earlier. It has been so easy for commentators to blame the 'financial crisis', as it evades the fact that there were changes taking place earlier, and that these were simply hidden under the cloak of massive extension of credit. The UK entered the 'financial crisis' already in a state of economic crisis. When looking at relatively benign inflation in the face of credit expansion, the impact of ongoing deflation driven by cheap labour and cost structures in emerging economies was not accounted for. The very real inflation in house prices was ignored; apparently that was un-worrisome inflation. When I first looked at the UK economy in any depth, it quickly became apparent that the boom years were built upon foundations of credit expansion, and I worried for the future and proposed that people were poorer than they thought. We can now see people becoming poorer in the decline in real standards of living, and the now steady decline in the value of most people's primary asset.

People are becoming poorer in spite of government borrow and spend, which is at astoundingly high levels. When consumers were unable to 'grow' the economy through more debt accumulation, the government tried to 'grow' the economy through debt. Spending tomorrow's income now is not a way to grow an economy, as it will see a shrinkage of disposable income in the future. As it is, private debt is now in a very slight decline. However, this slight decline is more than offset by the massive increase in government borrowing; but incomes still continue to fall. This only serves to illustrate the depth of the economic crisis that confronts the UK. Even whilst borrowing and spending more in aggregate, people were becoming poorer, and unemployment was rising. The UK has not even started to address the crisis that sits metaphorically in front of its nose. It does not take much imagination to see what might happen if the UK was to seriously try to balance its budget. Those £billions of debt generate a large amount of employment. What it does not do is generate underlying wealth; that wealth is generated in the primary commodity industries, manufacturing and the export of services. 

These sectors are the ones that are either sitting on plateaus or in decline. Sure, a flood of money into UK real estate might help tide the UK over for a little longer, but that is surely just another repeat of a bubble. There are still such temporary sticking plasters to cover the gaping wound in the UK economy. What these do not do is increase the ability of the UK to export goods and services, which allow the UK to trade in the goods and services necessary to sustain current standards of living. Quite simply, the UK is unable to compete well enough in world markets to sustain the current standard of living. In this post, I looked at government expenditure, and it is apparent that some expenditure is subject to upwards pressure; health care and pensions. These two expenditures look set to rise, even as the UK faces ongoing competitive pressures. In real terms, it means labour being taken from potentially wealth creating industries, and either being redirected into health care, or labour becoming inactive in increasing numbers. The ability to compete with such shifts in the labour force is a challenge the UK must face, in addition to facing the fiercer competition in the world. The UK is not, of course, alone in such challenges, but faces them whilst already struggling to compete. 

I keep on discussing this, but it does not do harm to say it again. The so-called 'austerity' of the current government is not austerity, but a luxury; a luxury that cannot be afforded. It is spending borrowed money to avoid confronting the real underlying standard of living in the UK. It is storing up trouble in the face of the challenges of shifts in the labour force, and a less forgiving world economy. So what is to be done?

The answer is to start to question what can, and cannot be afforded. My benefits reform is an example of how a principle might survive intact, whilst seeing reduction in cost. The aim is simple; to allow what was intended as a safety net to return to its original purpose. Real reform, the kind of reform that is increasingly necessary, requires that the shackles of historic legacies be thrown off. The benefits system did not start out as it is now; it evolved over time into what it has become. The same can be said of swathes of policy that comprises the foundation of government expenditure. If you look at the UK's tax code, it is possible to see that the (sometimes) good intentions of government after government has evolved into a sinkhole to drain away productive activity. Instead, the UK has a massive and fundamentally unproductive industry with the sole purpose of managing tax. Can the UK really afford to have so much productive capacity dedicated to what, in the end, is a process of collecting x amount of government revenue?

It is these really fundamental questions that must be asked, and asked of every area of government; what must the government do, how can it do what it must do differently and better, and where are the priorities for what government should do? These are the questions that are still not being addressed. In the meantime, the UK is becoming poorer. I see no change to this in current policy; but rather see the opposite outcome, which is an acceleration of the decline in the standard of living. After all, where is the policy to really address the poor and declining performance of the UK economy?

Note: I hope this is not too 'clunky'; comments welcomed on this and all points of the post. I have covered a lot of ground in this, so please point out any errors you may see.

Note 2: Shortly after publication - I am not sure I have made the best use of the data given - a bit like a kid in a sweetshop gorging without pause. Thoughts / comments welcomed.


Saturday, May 26, 2012

The UK Economy, the Euro and the Least Ugly Contest

I have, for a while, been focused on the Euro crisis, and I will not be the first to note that, as the UK's largest trading partner, the Euro crisis is set to have an impact upon the UK. It is therefore unsurprising that David Cameron (and also notably Barack Obama) has argued for Germany taking more direct action to support the Euro, in particular as it is Germany that is in the front of the line to pay the bill. Jeremy Warner of the Telegraph speaks for many when he says:
The stand-off got a whole lot worse this week. France and Germany are now in open conflict over the way forward, if indeed there is one. For the UK, already bleeding badly from the after-effects of the financial crisis, the situation could scarcely look more threatening.
 The fiscal consolidation chosen by the Coalition was always likely to have a negative impact on output, at least in the short term. To make it work, the Government needed the following wind of decent growth elsewhere in the world economy. Instead, it’s facing a hurricane. We look set to be broken by the storm.
There are no end of commentators expressing their thanks that the UK is not in the Euro, so I will not add to these. However, in response to the Euro, of particular interest is that Bank of England is yet again likely to go down the road of further quantitative easing (printing money). This from Reuters:


Evidence that both may be needed was sharply underlined by data showing that Britons have been shopping much less and factories getting far fewer orders.

In minutes of its May meeting, the Bank of England reported that while 8 of 9 policymakers voted to end a 325 billion pound round of asset buying to keep interest rates low, they had not closed the door on more.

Separately, Deputy Prime Minister Nick Clegg said it was an "absolute priority" to get credit into the economy and pledged to "massively" amplify what the government was doing in its 20 billion pound credit-easing scheme.

Both echoed a prescription delivered on Tuesday by International Monetary Fund head Christine Lagarde, who urged the central bank to buy more assets - possibly including company bonds and mortgages - and called on the government to find money to boost infrastructure spending.
Longstanding followers of the Bank of England's policy of printing money will undoubtedly recall that the policy was put in place with the justification that it was a unique circumstance that drove the policy. As has now been reported ad infinitum, the Bank of England long ago lost all credibility with regards to their original excuse of using money printing to prevent deflation. It now seems that, whatever might produce headwinds for the UK economy, the printing presses will start rolling. What has become an exceptional policy is now becoming routine policy.

We can see the same phenomenon in the US, Europe and Japan. There are two possible interpretations for the 'routinisation' of printing money; the first is that policy makers actually believe that it works, and the second is that they are now completely bereft of any idea of how to fix the ongoing economic problems.I go with the a mix of these two interpretations. For the former, I am guessing the Bank of England aim is a defensive attempt to pull down the value of sterling, out of fear of the impacts of a strengthening of sterling against the Euro. However, as an offset to this the resultant low interest rate will only encourage further borrowing, with potentially negative impacts upon the current account balance (see later, and chart below for the current account balance from ONS).
EU/non-EU current account balance

I have previously discussed flows of capital as a least ugly contest. Investing is no longer a case of looking for attractive investments, but trying to find the least unattractive.There is a catch, though; whilst investors may look for the least ugly, sometimes it pays for countries to be a little ugly. This pulls down the exchange rate, and this in turn helps to maintain a competitive exchange rate (regular readers may recall my example of Switzerland some time ago). Printing money might help with this, but the problem is that it is becoming a universal solution to trouble; right now, nobody wants their currency to appreciate and competitive devaluations are a real possibility. As it is, the UK economy is looking rather ugly without any further money printing:
The U.K. economy shrank more than initially estimated in the first quarter after construction was revised to show a deeper slump, which may bolster the case for the Bank of England to restart bond purchases.
Gross domestic product fell 0.3 percent, compared with a 0.2 percent decline estimated last month, the Office for National Statistics said today in London. Construction output fell 4.8 percent, the most in three years and more than the 3 percent initially estimated, while services and production were unrevised. Net trade and inventories subtracted from GDP.
I say 'rather ugly', as it must be remembered that this decline is still taking place in an environment of massive fiscal stimulus, with UK  government borrowing and spending supporting the economy at the cost of an anticipated deficit of £120 billion for the year 2012/13. There is no austerity anywhere in sight, and yet the UK economy is showing declining GDP. What is, in fact, taking place, is a slowdown in the rate of borrowing, as can be seen below (from the Guardian).

 
It is notable that this excludes financial interventions, which is the government's 'preferred' measure. More worrying is the cumulative total of debt being accrued, with the UK debt clock providing a graphic representation of the growth in debt.The Daily Mail provides a good summary of the current situation of debt in the UK, and it extends beyond concerns about government debt (I do not usually cite the Mail, but they are using some good sources):
There's also the not-so-small issue of Britain's household consumer debt problem which, in relative terms, is the second worst in the developed world.
They have a point. I checked the latest statistics from the Bank of England, and it sees a slow month on month climb in consumer debt. This helps to explain small increases in consumer spending even whilst real income is in decline. Again, from the Mail:
But there's also a misconception about consumer debt. There's much talk of businesses and households 'deleveraging' - paying off debts.

But in reality, Britons are not paying off what they owe. There were hopeful signs of this happening when mortgage rates fell sharply in 2008 and 2009 - some borrowers used the opportunity to pay extra off their mortgages. But consumers soon returned to form and began borrowing again to spend.

Even the falls there have been are due to banks writing off debts, according to the campaign group Save Our Savers (SOS). It points out that total consumer debt stood at £1,461billion in November 2008 and £1,452 billion in November 2011. But banks wrote off £26.7billion of consumer debt. So excluding the bank write-offs debt actually rose by £18.4billion.

Credit card debt continues to 'run rampant', says SOS, rising from £53.3billion to £56.5 billion over that time even thought an 'extraordinary' £13billion has been written off. Total credit card debt when write-offs have been stripped out has exploded by £16.1billion.

So the clear picture is that debts are not only still rising, by bad consumer debts are also just shifting across to become financial sector company debt which, if recent history is anything to go by, could one day become state debt.

And the projection, is that UK debt is set for another explosion. According to the Office of Budget Responsibility, personal debt will grow by nearly 50 per cent from £1.5trillion today to £2.12trillion by 2015.
More interesting than any individual sector is the overall picture of debt, and the graphic below paints the picture by including government, retail, financial and business debt.
The the UK's debt level is second only to that of Japan among major economies
These figures should be a cause for worry in all circumstances, but become even more worrying when seeing the UK balance of trade and current account. This from the ONS:
  • The UK’s current account deficit was £15.2 billion in the third quarter of 2011, the highest on record.
  • The trade deficit widened to £9.9 billion in the third quarter of 2011, up from £7.2 billion the previous quarter.
  • The income surplus was £0.3 billion, the smallest surplus since the fourth quarter of 2000.
  • The financial account recorded net inward investment of £22.0 billion during the third quarter of 2011.
  • The international investment position recorded UK net liabilities of £245.5 billion at the end of the third quarter 2011
This is a chart of the trade balance from the ONS:
 Trade in goods and services balance

 A quote from the explanatory note on the chart is given below:
The trade in goods deficit increased to £27.6 billion in the third quarter of 2011, the highest on record. Exports increased by £0.1 billion to £74.2 billion and imports rose by £2.7 billion to £101.8 billion. Both exports and imports are the highest on record.
In crude terms, UK borrowing and spending is a good way to help other countries export goods and services to the UK, and in particular goods. Sure, it increases activity in the economy, as distribution of the goods and services creates activity. However, this cannot be sustained forever. Whilst this has been the case for many years, there must come a point at which borrowing can go no further, and the earlier chart from the Mail highlights that the UK is now reaching a point where the unsustainable nature of the borrowing is becoming very apparent.

I return now to the question of the Euro crisis. As the situation stands, the situation in the UK has been continuing to deteriorate, despite talk of austerity and living within our means. Borrowing and spending is ongoing, and the UK is still consuming more than it can produce. Nothing has really changed since the onset of the financial crisis, excepting that the total volume of debt has increased, and is increasing. No real reform of the UK has yet taken place and the current account figures tell the real story.

Notwithstanding the lack of substantive action so far, the government appears to be genuinely seeking to reduce the rate of debt accumulation and, if it succeeds, as I have argued many times, this absolutely will see a fall in GDP. I have never accepted the absurd idea of expansionary austerity. However, as the earlier chart of total UK debt shows, austerity is a necessity as debt levels become unsustainable. Again, regular readers will know that I do not accept GDP as representing a useful measure of the economy, as GDP figures include activity from borrowed money. However, many take GDP seriously, and as GDP declines, the UK economy will start to look a little more ugly. In short, even without the Euro crisis, the UK was set to become uglier.

To add to these concerns, we have the accelerating Euro crisis and, on top of this, if the Bank of England prints more money, this will add a little more to the ugly factor, albeit partially offsetting this by possibly (temporarily) shoring up GDP figures. The question that this raises is how the UK will look overall in the least ugly competition. I would argue that, so far, the UK government has managed to convince the world that it is not so ugly and have done so with with the promise of future action. That action is now commencing, and doing so just as a shock is about to hit the UK economy in the form of the Euro crisis. The UK economy, as I have outlined, is in no state for this kind of shock, and the fallout of the Euro crisis will combine with the impact on GDP of genuine moves towards austerity. It is not a pretty picture. The UK may become very ugly.

The only possible offset is how ugly other economies will look as the Euro crisis accelerates, and this might allow for some kind of reprieve. In other words, the confidence in the UK economy will be measured by its relative ugliness to other economies. How ugly those economies will be will only become apparent as the Euro crisis accelerates. Perhaps the UK may yet survive a little longer in the least ugly contest, if only because some of the other contestants are going to become so very, very, ugly. Only time will tell, and whichever way this runs, the UK is heading for some very tough times.

Note 1: I assume here that the Euro crisis will not be resolved. I would never say that a resolution is impossible, but it becomes less and less probable as each day passes.

Note 2: I was hoping to respond to comments, but this took me far longer than anticipated. As such, please accept my apologies.





Tuesday, January 17, 2012

Debt and Economic Structure

In my post today, I am going to talk about the principles of structural debt reliance in an economy. It is (I hope) going to illustrate, in principle only, why so-called austerity causes a downwards spiral in an economy, and why denying the need for reductions in government borrowing are a fallacy. It is deliberately simplistic, but I hope that it will nevertheless make the point.

In order to illustrate the point, I will use a notional company that makes office 'widgets'. I choose this type of company as its products have broad applications (as all organisations use office supplies to some extent). We will imagine that our notional company makes 1000 widgets per week, and is a private company. At the starting point of the example, the government is borrowing money, but not excessively. Our widget company is supplying many organisations with their products, and they are a company in reasonable shape. Amongst their many customers are various government organisations, and these organisations purchase on average 200 widgets per week.

The widget company actually likes to supply these government organisations, as they have one particular advantage, and that is that they are government organisations. From this flow many benefits to our widget supplier. They pay on time, and most importantly, they seem to pose no credit risk. This in turn has benefits in, for example, raising finance, as the credit provided to the government is seen as rock solid. Overall, the widget company likes to supply to the government, and even hires a sales specialist who has knowledge of government procurement to help build this area of the business. Our widget maker starts to notice the growth of their business with government organisations, with government spending increasing over time. The money being spent by the government is increasingly funded through borrowing, not through taxation.

Our widget maker sees government sales creeping progressively upwards, moving steadily from 200 widgets a week, up to 300. At the same time, there are steady increases in sales from the other purchasers of widgets. With the ongoing growth in the business, our widget maker makes some new hires, and invests in new plant. The demand for their widgets is growing steadily, and they are struggling to meet the new demand for 1200 widgets per week, and will soon be turning down orders unless they invest. On current growth rates, they feel confident to invest in capacity for 1500 widgets per week. In order to grow their business, they visit their bank, and have a persuasive story of steady growth, reliable customers, and a growing stream of revenue with which to repay the loan for the new capacity. The loan is granted, and our widget company invests in expansion. All the while government borrowing is steadily increasing and the overall size of debt growing.

All is going well for our widget company, and then there appear to be tremors in financial markets. For many years, government debt has been growing, and concerns are starting to be raised about the degree of borrowing by the government. Words such as crisis start being used, and yields on government debt are rising. Raising new debt is becoming more difficult and expensive. There is talk of government cutting borrowing, and cutting services. Our widget maker is concerned, but not that concerned until the cuts to government expenditure start to be implemented. The number of widgets sold to government departments stops growing, and then starts to decline. The government sales specialist explains that the cuts by the government are limiting the spending of departments on new widgets, and that some of the government organisations are disappearing entirely.

Sales to government organisations start to fall back to the original 200 per week. It is a blow, but it is not that big a blow that our widget manufacturer cannot survive. After all, it was not just the orders from the government that were growing, but also the sales to businesses. They may have over-invested in new capacity, and repaying the financing of that capacity will be more difficult but not impossible. Time moves forwards, and the cuts of the government are starting to bite. Our widget maker once again becomes concerned. Whilst the government widget purchases have stabilised at the original 200 per week, the company notes declines in orders from some private customers. Also, some of his private customers are becoming tardy in paying their bills, and this is hitting cash-flow. The company is finding that sales overall are falling back towards the 1000 widgets per week, and they need at least 1100 sales per week to cover their cost of finance.

They are in trouble, and their cash flow is starting to be a problem for meeting their bills. They are themselves making late payments. They do not understand what is going on. After all, they had a diversified customer base, and were not reliant only on the growth in government orders to finance their expansion. However, they were unaware that many of their customers, just like themselves, were also supplying the government and like themselves grew (in part) through growth in government orders. And then there were the companies that supplied the companies that were supplying the government. And then there were the companies that supplied the companies that supplied the companies that supplied the government. In each case, they all see a deterioration in their revenue as government cuts bite, and each sees a negative impact upon their business.

The companies that are direct suppliers to the government are hit hardest. They are the ones now being tardy with paying their invoices. This tardiness impacts down the supply chain, with some companies not being paid for their products and services as companies start to fail. Our widget maker is now in trouble and is one of those companies. Their own suppliers are complaining about late payments, and are starting to restrict any new credit to the widget supplier. As credit from suppliers starts to disappear, and with now negative cash flow, our widget supplier is going bust. When the inevitable happens, the workers are laid off, and the bank takes a hit to its balance sheet. The liquidators sell off what remains of the plant and anything that might have value for creditors. The laid off workers look for new work, but with so many companies laying off workers, new work is difficult to find.

The laid off workers are unemployed, and they therefore tighten their belts. There is no money available for many things they had enjoyed before. For example, they would regularly go out to restaurants, but this is now completely unaffordable. It is notable that, whilst many restaurants are still in business, many restaurants are also going bust. It is not just restaurants, but other businesses that are closing the doors, such as shops, and hair dressers. And the shopfitters, and the wholesalers are also being hit. Yes, some businesses are still doing well, but the numbers of bankruptcies over a multitude of sectors are steadily rising. Even where businesses survive, they are often downsizing. Unemployment is climbing fast.

At this point I will stop. It is clear that this is a self-reinforcing downwards spiral. The managers of our widget business were, in all regards, perfectly competent business people and  managed their company in a sensible and responsible way. The market gave them positive signals, and they responded. As business people, they did everything right.

Our widget maker was directly exposed to government cuts, but was also indirectly exposed. As the borrowed money flows through an economy, the structure of the economy shifts to the consumption of that money. In some cases, as in the case of our widget maker, the shift in structure is readily apparent. In other cases, the shift in the structure of the economy is less apparent. For example, the small sandwich shop near the widget maker's factory that is doing good business as a result of the increase in the labour force in the widget maker. For example, extra staff may have been taken on to service the increase in business from the widget factory.

When we imagine the many interlinked ways that an economy restructures to service the debt founded consumption, it does not come as a surprise when we see countries such as Greece slide into a downwards spiral as government cuts borrowing and expenditure. It is the only possible outcome. There are those that propose the opposite course of action, which is to increase borrowing and expenditure, but the logic of this is that the economy will simply structure more deeply into servicing the debt based consumption. It will, undoubtedly, delay the problems, but only at the cost of more pain when the ability to accumulate yet more debt finally comes to an end.

Even if only holding debt accumulation at the current rate, the problem remains that the debt is accumulating, but the structure of the economy will remain the same; it means that the problem of a debt based structure is left unchallenged. One day, the economy must restructure away from the debt accumulation as infinite debt accumulation is not possible. There will always come a point at which the debt burden becomes too much, or where markets finally perceive that it is unsustainable.

When an economy structures around debt accumulation there is no painless fix. It is simply unreal to imagine that a restructuring away from debt accumulation might be undertaken without the period of the downwards self-reinforcing spiral. It absolutely must happen. The only question is to ask how much of the economy is rooted in debt consumption, how fast and deep the cuts will be. There are, of course, some things a government might do during this painful period, such as retraining, and other ideas to try to ameliorate the pain. However, there is no avoiding that the painful restructuring is the only way that the economy can move back onto a sustainable path.

Thursday, December 1, 2011

One Billion Idiots

As Europe sinks further into the sovereign debt crisis, I thought I would write about something of the foundations of the crisis. I have insultingly titled this post one billion idiots, and you are probably one of them. So was I, before I wrote this, and presumably so were many of my regular readers at one time. It is not pleasant to be called an idiot, which is why I have stressed that I too was an idiot.


This post is really for those who have still not asked the most simple question in the world; a question that every person in every developed country should be asking. My regular readers have now (I hope) asked the question of themselves, but there are many people who have yet to ask this simple, but powerful question. So what is this amazing question? I hope that you will not be disappointed, but suspect that you will be when you first see it.

Why is, and why has, the government of my country been borrowing money?


So, there it is. disappointed?

I suspect that you are indeed disappointed. It is a question that we have stopped asking, as it now so 'normal' that governments borrow money, we have forgotten that there should be a reason for their doing so. But what is that reason?

In the democracies of the rich world, as elections approach, there is discussion of economics. We listen to the to the back and forth of debate, we listen (if attentive) to the detail of the economic policy of party x and party y, and balance in our minds which has a better policy. Those of us who are most attentive might, just might, take into consideration whether party x and y will increase or decrease government borrowing. After all, governments borrow money, but they should not borrow too much money, should they?

Do you not think that this is odd, that we never really ask the one question that matters; why is it that both party x and party y both build borrowing into their plans for the economy? It is simply assumed that government borrowing is a normal state of affairs and that the question becomes one where we take into consideration how much they are borrowing, one against the other.

I am referring here to the 'rich developed countries', embodied in the OECD. These countries have something in common. They have complex and developed infrastructure in place. They have (had?) a large and wealthy tax base. They have the potential to raise enough money to pay for all of the functions of government from the wealthy tax base that sits as the foundation of the revenue of government.

So why is, and why has, the government of my country been borrowing money?

It is only when we ask this simple question that it becomes apparent that we have been idiots. There is no good reason, outside of (arguably) war (and less arguably) natural disaster that might justify government borrowing.  However, there are bad reasons, and we are partly to blame for these.

What a government is doing when it borrows money is giving us something which we will have to pay for later. Governments will tell us that they, the government, are borrowing money. But they are not borrowing the money; 'we' the taxpayer are borrowing the money. We are borrowing the money because, collectively, we will pay back the borrowing. So why are governments borrowing money on our behalf?

We, those who have to repay the borrowing, collude in the illusion that the borrowing is not our own. When we see party x or party y, we balance questions of how much taxation we will be paying under government x, and what services and benefits government x will provide for us. It may be that we vote for party y, because they will hold down taxes. Or it may be that we will vote for party y, because they will increase spending on benefit a, b or c. If we take the former, they are holding taxes down, in part, by borrowing money. In the case of the latter, the benefits are, in part, provided by the borrowed money. Whichever the permutation of taxes, services and benefits, these are provided, in part, through borrowed money.

But remember, they are not borrowing money, we are borrowing the money; we the taxpayers.

What we see is that the politicians appear to be generous to us; they are holding taxes down, or they are now providing a better service a, b or c. However, regardless of whether it is party x or y, they are bribing us with our own money, hidden in the form of debt. The real difference between party x and party y is how they use that additional money from our borrowing to please their own constituency of voters.The key election questions in the end resolve around how our tax money is distributed, and how our newly created debt is going to be distributed as it come due. If the debt allows for tax cuts, or holding back tax increases, person a votes for it, even though they MUST pay for it later. Or, even better, because party y will make person b pay most of it later. And the same situation with a promised improvement in service/benefit a, b, or c, all being subsidised now with debt that we must later pay.

This is why we are idiots. We are allowing governments to bribe us with our own money. Blinded by our own interest, as a constituency to be bribed, we allow the dishonest practice to continue. In all cases, in all developed and mature economies, governments should operate on current revenue. There is no reason to borrow, excepting to subsidise through debt, the interests of different constituencies; to bribe these constituencies through accumulation of taxpayer debt.

It really is that simple, and that is why we are idiots. We allow this situation, and we have colluded with this situation.

Note 1: I know that, for regular readers this is a little repetitive. However, I am struggling/attempting to make this point as clearly as possible, so that as many people as possible start to ask the question (comments/suggestions/alternative accounts welcomed). I returned to this subject as a result of a comment in which the commentator suggested that it was necessary to borrow money during economic downturns. It was the thought that we have become so used to government debt, people are just unable to see the possibility that a government might save money during the good times to ease the problems during the bad times. It is an answer that is obvious but somehow we became so used to governments signing debt on our behalf, we forgot that they might also save on our behalf.

Note 2: Lord Sidcup - thanks for the link to the Marxist economist. The author is heading in the right direction; he 'sort of' grasps the problem, but can't see that underneath the OBR figures (which he rightly identifies as dubious), there really is a structural problem. I also liked the link to the Hayman article. In particular that there is no playbook (I think that was their expression) for the current situation with global debt. There really is no precedent that we can look at, in particular if you throw into the mix a dysfunctional currency union. Of particular interest is the element that deals with psychology (one of my errors in the early days of this blog was to think that market participants would be logical in their approach to investing), as this has a large part to play.

Note 3: Death to Bubble Addicts - also, thanks of the link. I have looked at Chris's work on and off. The title of the presentation of 'unfixable' sets it on the right course. I liked the point early on about the impossibility of investing when we do not know what the ECB or Federal Reserve will do next week. The perfect exponential is interesting, and the 'red squiggle'. I think he underestimates shale gas (a subject I keep meaning to post on), but he is right that (at some point) we face some big questions, but the last question at the end of his talk is perhaps very pertinent.

Note 4: Sorry to not respond to other comments, links, but out of time....just a final note on the massive support being given to Europe from the US. If ever there were an indication of how serious the situation is, this is surely about as clear as it can be. I am going to be pushed for time for a while, but may come back to this later if possible.


Saturday, October 22, 2011

The Wheels are Falling off....

Oh dear, oh dear. Is the the grand project about to come to a crashing end? The EU and Euro have never looked as fragile as at this moment in time. However, there is a caveat; there is still a strong determination to hold the project together. The question is whether determination is enough in the face of the conflicting interests of very differently positioned EU members and in face of the storm that is now assaulting the EU and Euro.

I will not cite any of the news on the ongoing problems, as just about all the media are talking about the same problems; the fracture between the French and German positions, the IMF's reluctance to provide further bailouts for Greece without banks taking a major 'haircut' on Greek bond holdings, the growing resentment of the 'bailees', the proposals for a true financial union.Then there are the problems of the banks that are exposed to the risks of multiple sovereign defaults.

For all of the determination of politicians to save the grand project, it seems that the prospects for the EU and Euro to crumble are increasing. Of course, the former does not create certainty on the latter. However, if the Euro does crumble, will the political drive survive the recriminations that will follow? It seems unlikely but, again, it would be unwise to underestimate the determination of those who support the grand project. The EU as an institution will fight for survival in the face of any storm, and still has support of many politicians throughout the EU.

You will note here that the questions resolve around politics rather than economics, but now the economics are driving the politics. This is, in some respects, a reversal on the foundations of the EU and Euro in which politics drove the economics.

For the moment, I would like to just speculate on the scenario that there is no final resolution (which seems likely) which satisfies the financial markets. If this is the case, the crisis will hit hard. The reason is very simple - it is not just Greece that is overextended; it is not the only country that is unable to pay back the money that has been borrowed. I have long talked of the fallacy of GDP, that it includes activity that is derived from borrowed money, and in particular includes overseas borrowing. The way that GDP is measured sees increased borrowing from overseas creating activity in the borrower's market, and this gives the illusion of 'economic growth'. At present, for example in Greece, the economy is contracting even with borrowed money creating activity in the economy, and that is a signal for the state of the other 'at risk' economies.

There are some really fundamental points to consider here. The first is to return to a theme of this blog. Countries are unable to borrow money of themselves; they can only borrow and spend money on behalf of the tax base. As such, whether people or businesses, the ultimate borrower is the taxpayer. Some economists delineate public and private debt, as if they were different. However, public debt is in the end private debt as it is taxpayers that must repay the debt, not the government. The government just serves as the legal entity that signs for the debt, and then acts as a conduit for the repayment and distribution of taxpayer debt.

When we consider the position of Greece, or any of the other 'at risk' economies, it is apparent why the crisis is taking place. There are two possible purposes of borrowing and these are 'borrowing for consumption now', and 'borrowing for investment'. For the latter, provided the investment increases productive activity, it is generally a good thing to borrow money. I say generally, as this is not always the case, and this is where it becomes rather tricky to explain the problem. For example, investment in a restaurant will result in productive activities of 'making good food' or 'making convenient food' and so forth. It appears that it is a good investment. The problem arises when the investment is based upon a mistaken assumption about the real number of potential customers and the real underlying spending power of those customers.

If many people are reliant on borrowing for 'consumption now' as a determinant of their ability to spend in the restaurant, then there is a potential problem in the future. It is actually a double-whammy. If the people are reliant on borrowing to increase their spending power to be able to afford the restaurant, there must come a point at which they can no longer borrow, as they must be progressively accumulating debt, and that means that their debt to income ratio will be moving towards a negative. As such, at some point, they must switch from borrowing to repayment. At this point, they no longer have the borrowed money to provide the spending power to go to the restaurant, but also will have less money to spend on other things that they would have been able to buy, if they were not repaying debt. This is the double-whammy.

Now, if we return to so-called government debt, and remember that this is the debt of all taxpayers, then it becomes apparent that, when governments borrow, they are increasing the spending power of each taxpayer, but at the future cost of the double-whammy. If we think of our restaurants, the investment in these appears to be an investment in productive capacity, but in reality it is investment in over-capacity in relation to the underlying size of the market. Borrowing for 'consumption now' by both individuals and government has encouraged the development of capacity with a finite life. Meanwhile, those parts of the economy that, without the borrowing, might have been sustainable, get hit by the double-whammy. Not only can the taxpayers now not afford x, they can also no longer afford y, as they are now paying for the borrowing for 'consumption now'.

If we add in the accumulation of so-called private debt, or debt to which an individual has personally consented and has a personal repayment obligation, then it is possible to see how an economy can become distorted in creating capacity that is, in the long term, unsustainable, and which distorts activity and investment into over-capacity.

Now, we need to think of an individual German worker, for example working in a car factory. Our German worker is productive and helps in creating value in assembling cars. He takes home a wage, spends some of his wages, but also saves some of those wages. There are many ways of saving money but, for simplicity, let's say that he places the money in a pension fund. Included in the portfolio of the pension's investment fund are Greek bonds. Those bonds have gone to the Greek government, which spends the borrowed money in the Greek economy. This input of money from Germany increases activity in the economy, and will allow, for example, more Greek people to have the spending power to buy a German car. This in turn encourages an increase in capacity in the German car factory where our German worker is an assembly worker.

If we think of the way the system is working, it is as follows; in aggregate, lots of German workers are lending lots of money into the Greek economy. This allows the people to consume more German goods and services. In the financial industry, they say that this creates assets for the German worker, but those assets are actually debt obligations from (in the broad) Greece. They are only assets if Greece is willing to return the value of the asset plus interest. The problem is that Greece as a whole has been borrowing for 'consumption now', and even borrowing for investment was in many cases just supporting investment which was supported by borrowed money for 'consumption now'. The financial institutions that claimed they were buying assets with our German workers' savings were in fact primarily providing money for 'consumption now' for the people of Greece. The deal with 'consumption now' borrowing is that it must be matched (and exceeded because of interest) in the future by the double-whammy of less consumption, unless there are increases in productivity.

This is not to say that all of the borrowing in Greece was for 'consumption now', but the parlous state of the Greek economy is suggestive that this was a major proportion of the usage of borrowed money.

Squarely in the middle of this, we have the banks that lent the money. On their books, they have so-called assets. These are of course, obligations for x to pay debt. My intention here is not to go into the complexities of fractional reserve banking which I will leave to one side. However, some of the 'assets' purchased are not funded by inherently speculative use of savings, but by deposits which the banks must return on demand. If a debtor fails to repay debt, then the asset is in fact a liability. If enough debtors refuse or unable to pay, the bank will have greater liabilities than assets. It is bust, and all the depositors lose. In addition, those who gave the banks money for speculation will lose money (e.g. pension funds).

Staying with the Greece and Germany example, the problem is that Greece does not accept the double-whammy, and to do so would see a massive drop in the living standards of people in Greece. They simply do not want to pay back the debt to Germany. In some cases, in the case of 'private debt', there is simply nothing left to pay the debt back with; some of the sectors of the economy supported with borrowing for 'consumption now' are collapsing. The overcapacity supported by 'consumption now' is disappearing and with it 'assets' are disappearing. In the meantime, in Germany, for example where our car assembly worker works, over-capacity starts appearing as demand for German cars in Greece declines. Whilst it is possible that this capacity might be directed to other markets, what happens when other markets (e.g. Spain) see similar declines? How much over-capacity is there in Germany?

The really massive problem boils down to this. Money has been lent into supporting 'consumption now', and this money was lent without ever really considering how the consumption now might be paid back. In part, this was down to the flattery of GDP figures, but also due to banking regulations that pronounced that certain types of debt were safe. The problem is that there is nothing left to recover when debt is used for 'consumption now'. For example, the cars purchased with borrowed money are literally consumed over time (I use a physical entity such as a car for simplicity, but I hope that you can see the same point with services). Unless the Greeks now produce things of equivalent value to repay the Germans, massively reducing their own consumption in the process, the loss must take place. Unless of course, the Greek economy has an overnight miracle of productivity growth....

Then there are the savings of the Germans. If Greece does not meet its obligations, then the savings that have been poured into so-called Greek 'assets' will disappear. Even if governments borrow (from where?) to support the banks/other countries, the problem is that they are borrowing on behalf of tax-payers in order to protect those same tax-payers from losing money on their own savings. They do not lose their savings now, but they still have to effectively repurchase the same savings through the tax system. It comes back to the idea that governments can borrow on their own account. They cannot.

At this stage, I would like you to take a pause for thought. I would like you to think this through for yourself, as it puts a whole new context around the pantomime taking place amongst the governments of Europe. The tax-payers of Europe are borrowing money to bail out the losses on their own savings? Every Euro used by government to fill the hole of losses creates an exact equivalent of a Euro + interest obligation from tax payers on the borrowing. It is, of course, an absurdity. As there is nothing but tax-payers to repay the debt, it can only be a redistribution of the losses. And whoever lends the money to fill the hole from the bad debt, will want interest for their lending. Tax-payers bailing out themselves?  Or, here is a thought, is it that the taxpayer money is being used to save the banks?



I am, of course, simplifying overall. I have just focused on Greece and Germany, and excluded all the other actors throughout much of the discussion. However, when considering the big picture, we can see similar networks of relationships between individuals, economies, banks, governments etc. In the end, it is all about borrowing for 'consumption now', without the ability of the over-consumers to repay their borrowing. Meanwhile governments claim that they can save the day, but they have absolutely no resources of their own to use to save the day. They only have their tax-base to fall back upon, so that they are using tax-payer money to save the same tax-payers (or banks) from financial loss. The interesting part of all of this is that, if you listen to the news, you would think that it is governments, not tax-payers who are borrowing the money to 'save the EU' or 'save the Euro', or save the 'at risk' countries. In summary, the whole pantomime is simply madness.