Inflation, Deflation or Hyper-Inflation

It now seems that both the UK and US have now used up most of their interest rate ammunition, in their hopeless attempt to reverse the slide into depression. The result is a further sinking of the £GB, and even the 'mighty' $US is finally wobbling.

One of the most interesting features of the latest moves to arrest the slide is the minutes of the Bank of England, which revealed their fears for a run on the £GB:

"The Committee discussed whether a larger cut was warranted," the minutes said. "Financial markets had priced in a cut of 100 basis points and there was a risk that going further could cause an excessive fall in the exchange rate. There was also a risk that an unexpectedly large cut could undermine confidence in the economy more widely."

The £GB's recent slide was, in part, prompted by ever more dire news about unemployment, which is now surging ever higher, ever faster, in a mirror image of the US problems. The simple truth is that, as I always predicted, none of the measures to 'fix' the economies of the UK and US are working. We have this from the Telegraph regarding the UK:

In comments which raise the ultimate prospect of wholesale nationalisation of the British banking system, Mervyn King said that "additional measures" are now needed to solve the crisis.

The £500bn rescue plan unveiled by the Prime Minister in October and since copied throughout the world is not encouraging banks to lend more to families and businesses, he said.

It is the most stark warning yet from the Governor that all his and Whitehall's efforts to bring the crisis to an end have not succeeded.

Banks now need extra support from the taxpayer if they are to return to normal lending, he indicated. Facing the worst financial crisis in living memory, UK banks have slashed the amount they lend out to homeowners, resulting in higher interest rates and tougher conditions for homeowners.

I predicted when the bailouts were first proposed that the bailouts would be ongoing, and this is proving to be the case. In the US they are already printing money, and the Bank of England is now openly discussing the option. As each day goes by, as each new ever more expensive, ever more desperate measure is implemented, the relentless bad news continues. Up to now, each measure saw a brief rally in stock markets, but this time, the fed's rate cut saw a fall in the Dow Jones Industrial Average. Even the herd instinct of the markets are no longer following the scripts of government.

Just to add to the pain, it now seems that OPEC are going to drastically cut oil production, which can only serve to add fuel to the fire of the crisis. Low oil prices were one of the few true stimulants to the moribund economy that would have had a positive impact. We can only hope that their agreement fails to have teeth in practice. I still remember people arguing with me (about six months ago), that my prediction of $US 60 per barrel was absurdly low. It seems it was absurd, but not because it was too low, but because it was way too high.

There is still talk of deflation, and this is one of the justifications for the printing of money. In some respects it is correct that there are deflationary pressures. In particular, the housing bubble means that homes are returning to a more normal measure. I always argued that house prices should be included in inflation, and would still argue that they should be now. However, I am not sure how the deflation of a bubble could ever be considered to be a bad thing. Painful, yes, but bad, no.

Unemployment will also create deflationary pressure on wages. I was once shown a chart by an economist that 'demonstrated' that wages do not fall during recessions. It was one of those classic models that economists love. However, at the time, I merely pointed out that the deflation in wages was just displaced into unemployment. A company has a choice; make workers redundant or give everyone a pay cut. In most cases they will not ask for the pay cut, as it is easier to externalise the discontent through redundancy rather than trying to manage to persuade all workers of a need for a pay cut. As such there is displacement. It is at times like now that the minimum wage will have a negative impact. It makes it even more necessary for some companies to opt for redundancy rather than across the board pay cuts.

On top of these factors is the fall in the prices of commodities, such as oil. However, the prices of these items is not straightforward as, for both the US and UK, the prices of many of the commodities is tied to the exchange rate (though many commodities are priced in $US - more of that later). For example, in the UK, the prices of fresh food are on the rise again, due to the weakening of the £GB.

Howard Archer, chief UK and European Economist at Global Insight, said: "Sterling is having an impact as most of our fruits are imported. This is not something that is going to disappear."

But he added: "There are several factors at play which will lower inflation and they will substantially outweigh the effects of the pound."

Perhaps I am being unfair to Mr. Archer here, as the article does not detail all that he said, but at what level does he think the £GB will fall to? This is the critical question that needs to considered in thinking about inflation. My own view is that the fall has a long way to go, and that will mean strong inflationary pressure. As commodity prices are falling, so is the £GB, and where the balance between the two might settle is still unknown. In the case of the US, the $US has only just started to wobble, so the effects of downward movement of commodities have been deflationary. However, the $US bubble will burst, and when it does, the deflationary effects will start to disappear.

Another element in the consideration of deflation is retailing and services. I need not detail or even reference the dismal state of these sectors, as their poor state is being widely discussed in both the US and UK. Some months ago, when discussing the prospects for inflation, in relation to my prediction of a sinking £GB, I saw the collapse in services as a counter to the inflationary effects of higher import prices. This appears to be the case, as much of the fat in the service sector created by the credit boom is being trimmed.

So how does this add up in aggregate - in the prediction of inflation or deflation? It is here that we come to the really tough part, because there is the role of governments in all of this already complicated scenario.

I have already mentioned that inflation or deflation is strongly tied to currency movements in relation to commodity prices. As the world economy contracts, the supply of commodities relative to shrinking demand is rising, meaning prices should continue to fall. For regular readers, you may remember my analogy of the world economy as being like a person running forward, who then hits a wall of maximum commodity supply, bounces back from the wall, then commences running forward again (what has recently happened to the world economy). As I described it, the wall was also moving forwards, but not as fast as the runner so that eventually he would run up against the wall again, only to bounce back. In the case of OPEC's production cut, the wall is moving backwards, not forwards.

However, my prediction for commodity prices starting to rise again was about four years forward. I have mentioned before that OPEC is problematic, but it seems they are throwing a major spanner in the works with their production cuts. This is a wild card, as the price of oil is an important element in inflation for the world economy as a whole (despite some economists insisting it was not as important as before).

Another wild card is state of the $US. I am certain that the $US is the greatest bubble in history, and one of very few predictions I have made that has been incorrect is that the $US should already have sunk. I never imagined that people would be quite so irrational as to put their faith in a currency sitting on top of a collapsing economy. My error was that I expected people to act with at least some rationality. However, homo economicus was always a myth, so I should have known better. Putting my previous error to one side, the underlying weakness of the $US must emerge at some stage, so the wild card in this case is not 'if' but 'when'.

My reasons for why both the $US and £GB are fundamentally weak currencies is quite straightforward. The strength of the currencies previously rested on two platforms. One of these was inward investment, which was due to the illusion that the economies were successful, due to their credit inflated GDP growth, and the other was that creditors to both the US and UK needed to buy the $US and £GB in order to lend into each of the economies. With collapsing economies, the inward investment will evaporate, and nobody but a madman (or government) would want to be a creditor to both of these countries at present. At the same time, both countries make less and less of anything that anyone wants to buy. This is best seen in the ongoing trade deficits which, according to the Economist (print edition, 6th-12 December, p106) were $bn 851 for the US, and $bn 185 for the UK for the last 12 months. Inevitably, as the currencies of both countries sink, these deficits will diminish but, as things stand, there is is a basic imbalance (and has been for a long time).

Add to these currency wild cards are the exchange rates set for the RMB, which is a total unknown, dependent upon the wisdom (or lack of it) of the CCP in Beijing, as well as whether China seeks to rescue its own economy by attempting to redeem the I.O.U.s from the US and UK.

As if we do not have enough wild cards in the pack, we can finally add in the possibility that, if the $US starts to fall dramatically, the oil states that peg their currency to the $US might abandon the peg once the $US commences to collapse, and will the $US remain the currency of commodity pricing in general?

So where does this leave the question of inflation versus deflation? As you will note from the brief summary above, there are many factors that are inter-related. My view, based upon a heuristic evaluation (a smart expression for a 'guesstimation') is that any deflationary pressures in the US and UK at present will be strongly offset by a future currency collapse. The printing of money, in conjunction with the horrific level of government borrowing, will take a necessary and painful adjustment in currencies, and turn the adjustment into a complete collapse of the $US and £GB. In the case of the UK, the inflationary pressures have already commenced with the ever weakening £GB, but for the US, it will take a much firmer shove. However, if the $US does collapse, as I believe it will, I believe that the pegs and $US pricing will be unsustainable, leading to a 'shock' hyper-inflation.

Note 1: I am sorry to be so relentlessly gloomy, but I just can not see a positive side in anything that is going on. Even the bright point of the collapse in oil prices is now looking less positive. I am not sure I have covered all of the points here as well as I should, but I hope that the argument stands up. For regular readers, I am sure that much of what I am saying will make sense, as the foundation of what I am saying is built in many previous posts. For new readers, I would recommend the links at the top left of the blog.

Note 2: I have had some interesting comments again. Jeremy expresses complete cynicism, suggesting that whichever flavour of the politician, it will make no difference, and Steve Tierney expresses his concern that the public are buying the idea that the economy can be 'fixed' with ever more government borrowing and money printing. Steve reverses his previous optimism about people in face of the rising support for Gordon Brown due to his 'handling' of the economy. Like you Steve, I am endlessly disappointed (an anonymous poster also makes a similar point after reading the Guardian 'Comment is Free' section. I can not but help myself in agreeing with these concerns, and writing this blog is my small contribution to trying to make people face reality....

Also, an interesting comment from VKP who suggests that the UK and Greece have many similarities. I am not as familiar with the details of the economy of Greece as I would like, but am aware that they are running very large deficits. I have mentioned the possibility of the abandonment of the Euro, and the state of the finances of Greece is one factor in that consideration. I am not sure how much longer Germany will play ball.....

Note 3: If you thought I am gloomy, you might want to visit here if you want to see real gloom. An anonymous commentator recommends this blog.

Note 4: I have had some comments on my post on taxation reform. Lemming asks what I think about monopolies in my proposal. I still need to post on regulation, but I do think that one of the key regulatory roles of governments is to ensure that there is fair competition in markets. I do not have the quote to hand, but Adam Smith made a very good point about how, as soon as any group of merchants sit together, they will seek to conspire against the public. At least, that is the basic idea he is discussing...Lemming also, asks in a second comment what I think about individuals growing rich, and sucking money from the bottom to the top. In particular, he asks whether this pulling of money from consumers eventually leads to depression. It is an interesting point but, if the rich individuals invest this money into productive assets, then everyone gains. If the money is lent into consumption, then it will eventually lead to the mess that we are in now. I hope that I have not done Lemming's point an injustice, so you should read the orignial comments.

Also on the subject of taxation, Ivan makes the following point:

One thing, you mentioned tax free allowances - they would add massive complication and cost to a flat tax. I would propose that negative taxation would cover any free allowances, make the system simple and possibly finish up adding to the amount of tax collected.

I am not sure that having a single fixed tax free allowance is complicated, or am I misunderstanding your point? Please feel free to clarify, and I will (time allowing) try to respond.

Note 5: I have still not started work on the reform of the banking system, so apologies for this. I hope to get started soon, but have several distractions pulling me away from the subject. I will do my best....

Money Printing Economics - US and UK as the New Zimbabwe?

I am afraid that I am going to backtrack on my promise to post on the reform of the taxation system. I did mention that I might do so if the news (or events) are of particular significance. The news is indeed pointing me in that direction. In particular I have just read the last weeks edition of the Economist, had an interesting comment posted, and read some news in the Telegraph, all of which discusses so-called quantitative easing.

For those who have not encountered the expression, quantitative easing is the weasel worded expression for printing money.

This from the Economist magazine (a magazine I once had great respect for and for which I am a print subscriber):

'This is where the Fed has already been inventive: printing money to buy all manner of assets. In October it said it would buy short-term commercial paper. This week it unveiled two new schemes: a $600 billion plan to reduce mortgage rates by buying government-backed mortgage securities and the debt of America’s state-sponsored mortgage giants; and a $200 billion scheme to buy the debt backed by credit-card, car, small-business and student loans (see article). This approach could be broadened to other markets that have shut down. For instance, there is little fresh (senior) credit for firms in bankruptcy. If the government can provide that cash, it could stop the coming wave of bankruptcies from becoming one of corporate liquidations'

Apparently, printing money is now 'inventive'. Here is the same magazine discussing Zimbabwe:

'WITH prices doubling every few days, Zimbabweans now spend huge amounts of time and energy preventing their meagre cash resources from completely evaporating. Trying to catch up with galloping hyperinflation, now officially running at 2.2m per cent a year and at least four times faster in reality, the central bank has been printing ever bigger denominations. But it is outrun by galloping prices:'

And:

It may seem odd that the local currency is still used at all. From Z$25 billion to the American dollar at the beginning of this month, the cash exchange rate had jumped threefold within a fortnight. In restaurants or shops, prices are still quoted in local currency but revised several times a day. Salaries are paid in Zimbabwean dollars, still the only legal tender. A minibus driver taking commuters into Harare every day still charges his clients in Zimbabwe dollars—but at a higher price on the evening trip home—and changes his local notes into hard currency three times a day. The local money is losing its relevance.

So apparently the printing of money is a disaster in Zimbabwe, but if Western countries do it, it is 'inventive' and to be commended.

The following is a comment on my last post:

'The press is suddenly awash with the notion of " quantitative easing " the helicopter strategy is now seriously being prepared by the boe and ecb, the printing presses are being readied.

It seems that the govt has no intention of borrowing the money when it is so much more convenient to simply print it.

How do you see this playing out and how quickly will deflation turn to rampaging hyper inflation. Presumably, investors will flee sterling as soon as this policy is enacted.

Will this hasten the end, or will it result in the mother of all dead cat bounces before the structural problems induce the final plunge?'

If we compare the comment above with the Economist, I think I that the anonymous poster on this blog has a better grasp of the situation.

Another commentator a while ago asked whether the UK would follow the US in this policy of printing money. I have this from the Telegraph:

'In what would be a major departure for British monetary policy, the Bank is considering pressing the button on printing presses by engaging in a so-called policy of quantitative easing. It emerged after the Monetary Policy Committee cut borrowing costs by 1pc to just 2pc - the lowest level since 1951.'

As is painfully illustrated by the case of Zimbabwe, printing money is the surest way of destroying the value of a currency. Now the really odd part is that there is a claim in the same Telegraph article that:

'The radical proposals, which are currently being explored by Bank experts, could be put into action within weeks, although they would have to be vetted by the Treasury, which is thought to remain sceptical. '

As I have already pointed out in previous articles, there are storm clouds on the government borrowing horizon. The article in the Telegraph proposes that the printing presses may get started in a few weeks. This is about the time that I predicted a government debt default, and at which time I suggested that the government would be faced with either - you guessed it -printing money, or default. Bearing this in mind, the idea that the treasury opposes this move looks to be very dubious.

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

At this stage, some readers may be tempted into thinking that this is all well and good. UK Plc is the winner, and those poor foreigners lose out. The same argument can be said for the US and other countries that go down this route. However, as we can see from Zimbabwe, this is not a winning situation. The first problem is that the currency will collapse, making every single import into the UK horrendously expensive, thereby impoverishing everyone. The second is that the devaluation will destroy the value of savings and investments. Thirdly, you end up with a currency in which no one has confidence, even leading to a move to barter, much as is the case in Zimbabwe.

The people who appear to gain most are those who have huge debts. They will see their debt diminish with the hyper-inflation, but this will also mean that nobody will lend any money, including investing into businesses, except at insane rates of interest, but even then very rarely (excepting the government who can just print more to lend, thus enhancing the hyper-inflation). I pointed out in a previous post that the value of a currency is entirely based upon confidence, and the loss of confidence means that there is no more saving, no more investment, nothing but the most crude economic activity fixated upon immediate consumption before more value is lost in the currency, and finally with money fleeing the country in search of a safe haven.

It is a situation in which the cautious and responsible get burned, and the spendthrifts win. However, even the spendthrifts lose in the end, as the general economic collapse hits everyone. This, as the anonymous commentator has identified, is a recipe for complete disaster. I seem to remember another commentator asking whether there would be food shortages, and my suggesting it could not get that bad. Getting the printing presses started is a good road to take you to that situation - though I still do not think it will get that bad (I hope).

I will return to the anonymous poster's question, which was:

'Will this hasten the end, or will it result in the mother of all dead cat bounces before the structural problems induce the final plunge?'

I will confess that I am not sure of the answer here. It all hinges on confidence, and how quickly it evaporates, and how quickly the currency sinks on international markets. That will, in part, be determined by how quickly the banks churn out the money, how they spin it, and how long it takes before everyone gets wise to the damage that is being done. There may be a bounce, but I can't see it lasting.

The one certainty is that it will make an already catastrophic situation even worse. When I predicted the default all that time ago, I did think about the option of printing money, but saw it as a last resort to pay government workers, whilst the government tried to scale back expenditure. This is different, as it is an attempt to print the government out of the black hole, and will just lead it deeper into the hole. In both cases it is an act of desperation, but doing so before it is the last resort has the suggestion that people actually think that this is a good idea.

That is very scary indeed.

Note 1: Pocmloc asks me this about the forthcoming taxation post (about half written now).

'I noted your past welfare proposals. have you ever done any analysis of ideas along the line of flat tax/national income/no benefits schemes? They seem superficially sensible but no one takes them seriously enough to say what their real effect on the economy would be'

You will be please to hear that this is at the heart of the proposals, but more of that when I post.

Note 2: I have to go in a moment, so will post this 'as is'. I hope there are no errors...

Note 3: I have just found this article, which may be of interest to those who read my previous post. It mentions that there is growing unrest an industrial heartland of China - Guangdong. Guangdong was the first part of China to open to the West, and has been leading the way in trade of many exportable goods. The boom has also seen large numbers of other Chinese people move to the province, as the pay and work prospects were so good. If Guangdong is hurting, the rest of China will follow.

Note 4: I forgot to add a link and quote in the above post, which is for the following article which was provided in a comment (apologies for not citing it earlier, and thank you for the link):

How quickly could the United Kingdom go bankrupt? Given the speed at which countries and companies have been brought to their knees in recent months, it is no longer hard to envision a scenario in which foreign investors become spooked by the UK's soaring debts and flee.

If you have time, it is an interesting read.....

Note 5: A commentator, Jeremy (see comments below) has very kindly referred me to national statistics and points out that M4 is at a very high level. The definition of M4 from the bank of England is as follows (link takes you to BoE page on which there is a link to a Word document):

• UK private sector's (for first time defined as the non-bank non-building society private sector) holdings of:-
• Sterling notes and coin; plus Sterling deposits (including share certificates of deposit) with banks in the UK; plus Building society shares, deposits, and sterling certificates of deposit.

At the most basic level, M4 is the money sloshing around the UK economy. At present M4 is £billion 1 718.3, compared with £1 538.2 in 2006/7. The same statistics show that there has been a steady rise in M4 during this year, and that the numbers have been climbing faster through the last few months, commencing in July.

The important point here is that, if the money supply expands faster than output, then inflation will follow, and output is falling. The most simple example of the principle of money supply and inflation can be seen in the housing boom, in which creditors injected large amounts of money into the UK mortgage market, with a finite supply of housing, thereby pushing up prices. i.e. if you have more money chasing the same number of goods, then prices will rise. What I believe Jeremy is pointing out is that there is an inflationary impetus within the economy. The spectre of deflation has been promulgated whilst inflationary circumstances exist.

If we look at the other statistics for the UK, we see that inflation is going down. From National Statistics, we see that the Consumer Price Index is showing a -0.2% drop for October, but that inflation still remains reltively high. A report from the Telegraph says the following of shop price inflation:

'Overall prices were 2.7pc higher than the same month last year, compared with 3pc in October and a peak of 3.8pc in August, and the BRC said that there was more deflation to come following the VAT cut to 15pc from 17.5pc. '

The answer quite simply is that the slowing of the rate of inflation reflects the decline in commodity prices, as well as deep discounting by retailers. However, as Jeremy points out, there is still a relatively high rate of inflation. What we have are opposing factors. On the one hand, there is the increase in money supply, and on the other we have the discounting in retail, as well as the falling back of commodity prices. To add to this, we have the fall in the value of the £GB which is inflationary, as it will make the prices of imported goods higher. This is a fairly simple explanation of what is going on, but I will try to expand further on what all of this means later.

Note 5: Lemming (see comments below) has passed on a fascinating link to an article, in which it is apparent that the new Banking Bill means that the BoE is no longer obliged to publish details of their issuance of money. Bearing in mind that we are currently being prepared for the printing presses to be started, this looks mightily suspicious at this particular moment. I recommend viewing the article here.

Regular readers will know that I am the arch cynic when it comes to conspiracy theory. However, this is looking more than a little 'iffy'. It is just too much of a coincidence. It looks like the politicians have grasped the severity of the situation, know that they are about to default, and are hoping to hide the fact that they are about to attempt a 'Zimbabwe'. That they think that this will go unnoticed, is damning indication of their competence.

Thank you, Lemming, for such a useful link.

US Economy - Descent into Madness, and the Politics of Desperation

Much of what I will be writing will be a mirror of my last post on the subject of the UK. It seems that economic madness is contagious and spreading throughout the western world. The seeds of the fall of the West were sown a long while ago, with the last ten years a period in which economic policies have accelerated the decline. The current economic crisis has been an opportunity to recognise the weakness of the West, and therefore an opportunity to reflect on, and correct, the errors of the past.

Instead, what we have is the collective burying of heads in the sand.

The latest news out of the US makes gloomy reading. We have this from the New York Times:

'Instead of trying to reduce overnight lending rates in the hope of influencing longer-term interest rates for things like mortgages, the Fed is directly subsidizing lower mortgage rates. It is doing so by printing unprecedented amounts of money, which would eventually create inflationary pressures if it were to continue unabated.

For the moment, Fed and Treasury officials made it clear that the sky was the limit.

Treasury Secretary Henry M. Paulson Jr. emphasized Tuesday that the $200 billion was just a “starting point” for a program that could become substantially larger, possibly including other assets like commercial mortgage-backed securities.'

So here we have the answer to the current crisis. Print money. I'm afraid, for all of those who thought Barack Obama was offering a bright new future, you should be deeply disappointed, as this is apparently the course that he is setting (same NY Times article):

'As if to underscore the transfer of power now under way, Mr. Obama introduced his economic team at a news conference in Chicago on Monday shortly after Mr. Bush made brief remarks outside the Treasury Department.

Mr. Obama expressed support for the Citigroup plan and urged Congress to adopt swiftly a major plan to stimulate spending and to reverse job losses.'

And the purpose behind the printing of money is to stimulate the economy through the encouragement of lending into home purchases, car loans and small business. In short, it is another case of consumers being unable to borrow, so the government will make up the shortfall. The difference between the US and UK is that the UK borrowed to subsidise consumer spending, and the US government is printing money. Both are acts of lunacy, both are signs of desperation.

In both cases there is the fundamental belief that when a consumer buys something, wealth is created. In the case of the UK the purchase is being made through government borrowing, and in the case of the US being made by handing over money on which the ink is still wet.

I have had a comment from a poster asking me what I mean when I say 'real' wealth creation, and this is very valid question in this context. For regular readers, they will be aware of what I mean by 'real' wealth, but for those who are new to the blog I will briefly explain what I mean. However, I would also recommend following the link to 'A Funny View of Wealth' which explains the point fully (it is long, but I hope that it is worthwhile).

In the meantime, a brief explanation of what I mean by 'real' wealth. The best way of starting is to say that real wealth is not borrowing and spending, which is just foregoing of future wealth. When a person borrows and spends, it creates an illusion of wealth in an economy. When a person goes to a restaurant and pays for their meal with a credit card, the process creates economic activity. The restaurant (if it is well managed) will make money, and they will then use that money to pay their staff, to buy materials, services, equipment and so forth. Each $1 spent with the credit card gets used many times to create activity. The staff will spend money on buying things, the equipment manufacturers will get another sale of a piece of equipment, and will therefore pay their staff, who will in turn spend that money and so on. This is the multiplier effect. Each $1 spent will create lots of activity throughout the economy.

The problem here is that GDP is a measurement of economic activity. Somehow, GDP has been seen as an indicator of wealth. However, if the activity is created through the use of borrowed money, then no wealth is being created, just future wealth is foregone. The important question that needs to be asked when considering GDP is to ask what is the source of the economic activity.

For example, if another person goes into the same restaurant, a manufacturing worker, a miner, or an architect who works in a practice that sells services around the world, and spends money from their earnings, this represents the redistribution of real wealth. In all cases the economic activity of the individuals has produced real wealth, in one case by being a part in the creation of a product, in the other case exchanging their services, and in the case of the miner extracting and making available a commodity. More to the point, as long as they keep their jobs, they can keep returning to the restaurant and keep spending their earnings. This represents real wealth because it is sustainable. On the other hand, if the same people were to use borrowing to make the same purchase then, at some point in the future, they will not have that money available to buy another meal in the restaurant.

When this is multiplied accross an economy, with 100,000s of shops and restaurants, it becomes critical to ask what the source of consumer spending actually is. In 'A Funny View of Wealth' I looked at the UK economy and asked where the economic growth came from, examining the rates of increase in manufacturing, commodity extraction and export of services. None of these showed any significant increases that could explain the GDP growth but, over the same period, there was a massive increase in debt (government and consumer). This massive increase in debt, when considering the multiplier effect, is the explanation of the increase in economic activity. The growth in debt therefore gives an illusion of wealth creation, but the reality is that there is a massive amount of future wealth being consumed. At its most simple, if I borrow $100 to go to a restaurant today, it means that in the future I will not be able to go to a restaurant one time in the future.

When a government borrows money it is doing exactly the same thing. If the government borrows money, it is foregoing future wealth, just on a much larger scale than individual consumers. If the government pays the wages of policeman out of borrowing today, at some point in the future they will have to accept that they will have to have one less policeman (actually more than one policeman because of interest) , unless they increase taxes. If they increase taxes, individuals will have less money to go the restaurant and buy the meal that will then allow all of the multiplied activity in the economy. Essentially, any borrowing that is directed towards consumption will one day be paid for by less consumption and therefore less economic activity.

The only way to overcome the problem of borrowing for consumption is to create a huge increase in real wealth, which means more commodity extraction, more manufacturing or more export of services overseas thereby transferring wealth from other economies into your own economy, or using your wealth to lend to other countries, and thereby transferring some of their wealth into your economy in the future.

Borrowing is not all bad. If the borrowing is going to pay for a new mine, a new manufacturing facility, or any other asset which produces more wealth than it consumes. Borrowing for consumption is the problem.

So now we can return to the various stimuli of economies being proposed and enacted by Western governments. They are doing nothing to address real wealth creation, as the provisions of the stimuli is to encourage a resumption of consumption. This is being achieved through borrowing, and also the debasement of the value of the currency. In the former, they are just creating new future problems, and in the latter they are destroying the value of the currency, and thereby literally destroying the value of the wealth that has been stored by every individual and business. Perhaps the US politicians should take a trip to Zimbabwe to see how helpful the printing of money is for making a country wealthy. I have talked about the value of currencies before on the blog, and I would therefore recommend reading my post on 'Synthetic Economics' to those who have not already read it. It is not easy, but I hope it will explain why printing money is so foolish.

At the risk of boring regular readers, I will reiterate that none of these solutions is addressing the fundamental problems in the UK and US economies. In both cases the economies are simply unable to compete with the emerging economies, and they are therefore structurally bankrupt. The only thing that is supporting them is the ongoing belief of creditor nations that they are 'good for' their debts. The truth is, they are not. They are just borrowing more for ongoing consumption and doing nothing to address their inability to compete with the emerging economies. In borrowing so much, they are actually damaging their ability to compete with the emerging economies in the future, as the economies will have less capital for investment into productive activity, due to the requirements of servicing the debt. In the case of printing of money they destroy the value of the currency, thereby impoverishing everyone.

I find it ever harder to accept that this is actually happening before my eyes. As each week goes by, I just see the situation become ever more dismal. I think the discipline of economics needs a new term, which is 'car crash economics'. This would be defined as the economics of slow motion destruction, in which onlookers watch helplessly as a the economy careers towards destruction.

I have now given up any hope of sanity in economic policy. My curiosity is to see whether there is anything that can be done to top the foolishness that is taking place. It is the curiosity of seeing just how mad policy can become. Each time the latest 'fix' is announced, I thought that it could not get much worse. Each time I have found my belief confounded.

How mad can economic policy become? Comments welcomed....

Note 1: I will return to the post a little later, and will address some of the comments and questions that have been posted. For a change, I have a little more time on my hands....

Note 2: Jonny posted this very interesting comment:

'Consider the following two actions by the UK Government:

1. In December 2003, Gordon Brown "changed the Government's inflation target to a new base: a CPI of 2%, from the previous target of RPIX of 2.5%."
(FAQs: The UK target measure of inflation, ONS website)
"The CPI excludes a number of items that are included in RPI-X, mainly related to housing, and as such is considerably lower ... The two indices are also calculated differently. The different techniques used to combine individual prices in the two indices also reduces CPI inflation relative to RPIX."
(http://www.moneyextra.com/dictionary/consumer-price-index-003666.php )

2. It can be seen that the growth rate of broad money rose from 7 per cent in January 2004 to above 14 per cent by the end of 2006. (http://www.marketoracle.co.uk/Article2880.html )

So, the measure of inflation was changed to omit house prices and immediately after this the money supply was progressively increased from medium to high. The result was artificially low interest rates despite both monetary inflation and soaring house price inflation.

If the UK Government did not want to exacerbate house price inflation then surely it would not have undertaken these actions simultaneously.

Is it therefore reasonable to conclude that this policy was adopted by the Government to prolong the credit bubble?'

I think that the answer to the question is that, yes, it appears that the government sought to prolong the bubble. If I remember correctly, I wrote of a couple of other methods in 'A Funny View of Wealth' that were used to maintain house prices when they started to wobble. I do think that the government sought to prolong the boom, but do not think they had any idea of the price that would be paid in the end. Whilst I have no respect for Gordon Brown's economic policy, I do not think he would have acted as he did had he known what his foolishness would lead to. I think that there are very few politicians who are quite that corrupt/wicked, but there are plenty that are happy to self-justify or willing to delude themselves.

Jonny also asked the following question:

'If the UK Govt defaults how would that affect UK banks, specifically UK saving accounts?

Basically what can I do with the money I have set aside to buy a house?

Advice urgently needed as my head is in a spin....'

I think that many people will be in the same situation. I am very wary of giving any specific advice, and you should see my comment at the bottom of each page of the blog. I think that it is difficult to give any firm advice on where might be a safe place for money right now. The world economy is in a state of chaos, and that means that small events might change larger events very quickly. One question to ask is how long you want to hold the money before using it. My guess is that house price declines will hit the bottom in 2-3 years time, but that is a guess. However, after that there will be stagnation for a long time, but it is also possible that there will be very slow erosion of prices for a while after. In this kind of timescale (3 years) the world economy is going to be turned upside down. My belief is that in about 4 years time, commodities will be on an upswing, so countries with sound economic policy (minimal debt) and a strong commodity base will be a good bet over the period of house price falls.

Also emerging economies with sound economic policy and not too much political risk might be a good bet, but I can think of no country without considerable political risk in the coming years. I even think that many OECD countries are subject to political risk in the coming turmoil. Set against this, I believe that holding £GB, $US are surefire ways to destroy wealth. The Euro is more of a question mark because, as I have highlighted elsewhere, the Euro economies are such a mixed bag that it is hard to see for certain what might happen. In addition, the coming problems are likely to see strains on the continued existence of the Euro in the coming years, such that you should only put your money in Euros where it will default to stronger currencies, such as a revival of the DM.

As you can see, we are confronting a world full of question marks. The only certainty is that the decline of the West is now assured, and that will, to a greater and lesser degree according to each country's response to the crisis, lead to devaluations relative to the rest of the world. I am not sure whether the answer is helpful, but it is the best I can do.

Note 3: Steve Tierney made the following comment:

'My gut feeling says you are, sadly, right in most of what you say.

What I don't understand is why the UK Government, or the opposition, both of whom have plenty of economics "experts" on hand, aren't terrified. They MUST know how bad things are. Why is nobody saying anything?

You can understand why conspiracy theorists get so excited. It just doesn't make sense that we are balanced on a precipice and people are arguing about whether the voting methods of reality shows are right...'

I think that the trouble is that they do have so many 'experts' on hand. The experts have still not actually managed to grasp the idea that, when the world labour force doubles in ten years, there must be economic consequences, and that this has never happened in the past. In such circumstances, where they are using the past as a guide, they are going to get everything very wrong.

Note 4: An anonymous commentator left this very interesting link:

'Very interesting reading:

http://blogs.telegraph.co.uk/ambrose_evans-pritchard/blog/2008/11/24/is_britain_going_bankrupt'

The article in question highlights that the bond markets are getting increasingly nervous about UK borrowing. The author ends the article with this:

'The situation is desperate, but not serious - as the Habsburgs used to say. Fingers crossed.'

I am not sure that crossing your fingers and hoping is a good response to the risk of government bankruptcy....

Note 5: Lemming has posted a provocative question, to which I think he knows the answer:

'Alistair Darling on the Today Programme this morning:

"...debt levels as we go into this are lower than other comparable countries because we did reduce debt over the last 10 years... our debt levels did fall over the last 10 years; by any measure they fell..."

(about 14 minutes into the interview)

Is what he says correct'

Let's start with the 'sunny' picture of government debt, which can be found here on the ONS website. On the other hand, as others have pointed out, this does not include liabilities such as unfunded pension arrangements, and also the ever growing use of PFI to put debt off the balance sheet. A good discussion of this can be found here. It is fairly partisan source, but that does not mean that it is not correct, as it uses the IFS for the numbers. Here is a good summary:

'Add up all the money pledged through PFI, and the independent Institute for Fiscal Studies believes that you will quickly reach the sum of £110 billion. The institute’s findings suggest that, were this PFI lump-sum added to officially acknowledged government debt, the total figure would represent 45 per cent of gross domestic product — making a mockery of Mr Brown’s ‘sustainable investment’ rule, by which government debt is not meant to exceed 40 per cent of GDP. If this seems no more than a statistical abstraction, think of it this way: the overall national debt works out as £26,100 for every British household. This amounts to a second mortgage which all of us, including our children, must eventually pay off. And this is before the consequences of the Northern Rock crash or the £1 trillion of unfunded public sector pension liabilities are factored in.'

As if this is not bad enough, everybody is measuring debt as a percentage of GDP as an indicator of the sustainability of debt. The trouble here is that GDP has been measuring activity that has, in part, been inflated by debt, as I have already outlined. Under these circumstances, my estimate of non-borrowing based economic activity means that the real output of the UK economy is around a 'guesstimated' 30% less than GDP states. In other words, the level of debt in relation to output of the economy is quite simply shocking.

I think that Lemming was already aware of this and asked the question so I could make the point for others.

Note 6: I have had this comment from an anonymous poster:

'If the US continues on this course of printing money, what will be the likely reaction of those nations holding large dollar reserves. Given the implications of inflation on the value of the dollar, wont those countries dump like crazy as soon as US inflation climbs.

IMO if the americans are up to this, it wont be long before the UK follows suit. Given the much weaker UK position re sterling, would this cource of action precipitate an immediate collapse of the currency.'

To the first question, 'yes', is the short answer. Printing money just destroys the value of money, so why would anyone want to hold it. To the second point, I have speculated that the UK will print money to try to get out of trouble, but as we know it just creates a whole new set of even worse problems. With the US leading the way, this is quite likely. However, I am not sure the BoE, however many errors it has made in the past, is going to go along with the idea of printing money until there is nothing else to be done. That will be at the point of default. However, as I have already mentioned, there does not seem to be any limit on what foolishness might be enacted next, so perhaps I will be proven wrong.

Note 7: Chas H has kindly provided an explanation of how a chart I found (last post) shows a decline in the number of civil servants. His comment and link is as follows:

The explanation for the strange bar chart at the end of your 24 November 2008 post may be found here: http://www.civilservant.org.uk/numbers.pdf
The pie chart at the beginning of the document and the graph at the very end are particularly revealing. The distorting visual impact of the bar chart you found is heightened by it's use of a false zero and the cunning way it starts at 1999 instead of 1997.

Thank you for that. If you check the orignal chart here, and compare it with what Chas has provided, you will see how 'playful' the numbers actuall are.

Note 8: Steve Tierney suggests the following:

'Most people are afraid, first of all, of losing their home. Some protection to prevent this during the crisis would go a long way to settling public nerves, if not resolving hardship. Perhaps by protecting people who lose their jobs from repossession (if they bought the house before the start of the current crisis.)'

I can understand Steve's concern. There will many people who lose their job as a result of circumstance, rather than their own behaviour. I think the answer to this problem can be found in my post on benefits, which can be found here. The system I am proposing is largely self funding, so would offer a route to achieve the objective without increasing unfunded liabilities significantly.

P.S. Please do not joke about faeries being enlisted to solve the crisis. Someone might read your comment and think that it is a good idea......

Note 9: I have had the following question from an anonymous poster:

'Given the recent lunacy by the government and the extra £ 450 bn borrowing figure, which will be wildly exceeded as its based on what can only politely described as optimistic growth figs.

Have you revised your forecast for a UK sovereign debt default ie brought it foreward'

It is a good question. I think that we are coming very close to the point now. When commentators in the mainstream media start to ask the question (see earlier note), then I think that the situation is coming to a head.

Note 9: I have had so many comments that I have not been able to cover them all, so accept my apologies if I have not responded to you individually. Whilst I have more time, for once, there is still a limit to how much I time I can put into the blog. I am hoping (events allowing) to make my next post on the subject of reform. I have just had to prepare and deliver a presentation on energy policy so, whilst it is a quite specific, I thought it may be worthwhile posting on how to make the energy sector more efficient.

Note 10: I have just read an interesting article in the NY Times which suggest that the UK government has adjusted its policy on Tibet as a quid pro quo for financial support from China. I think that the point being made is quite believable. Maybe the UK government has managed to buy some time at the cost of abandoning principle?