Friday 21 March 2008

We Live in Interesting Times

"False interest rates and artificial liquidity create great illusions of wealth in business equity and real estate .... In the early stages of every instance of credit expansion and inflation, there is always optimism. People do not want to pay attention to the warning voices of economists. They stubbornly insist that their present situation has nothing in common with the boom periods of the past, and that the theorists are wrong in predicting the breakdown of the 'prosperity'."
Hans Sennholz (February 3, 1922 – June 23, 2007)


For the past decade or so we have all witnessed an increase in our purchasing power. Assets have rocketed in value, businesses are making record profits, employment has been at record levels and credit has been plentiful. People assume that we are in a new era of prosperity, that our economy is strong, that in some way we all earned this prosperity. In reality we are living beyond our means, and we will all realise what a real severe recession is like.

America is in a similar position to ourselves and they are just coming out of this era of cheap money with the reality of the situation only just beginning. There is a lot of discussion in the financial world that we are witnessing the end of an empire in America. It is running huge govt debts, has a massive trade deficit and is debasing its currency (Incidentally this is how the Roman Empire ended - by debasing its Gold currency). And yet all of the above applies to the UK. We have not yet actively begun debasing our currency like America - we don't need to the world can already see how exposed and weak our economy is and Sterling has been the only currency falling along with the dollar. We are more in debt than our American counterparts yet all the government can say is how strong our economy is - this rhetoric will not help in the coming downturn.

So how did we get into the current situation? A combination of factors, but due to the deflationary effects of China and the new CPI measure for inflation our central banks could pursue an ultra expansive monetary policy, round about the turn of the millennium. Our Broad Money supply has increased exponentially in the past decade. All this broad money is created through debt being sold, and the UK has become a leader in escalating the debt levels of its people. This is where the mirage begins, our economy is one large debt mountain waiting to implode. Instead of producing goods Britain has decimated its manufacturing base and has become a consuming nation. Britain is now one large service economy that actually produces very little, even America produces more proportionately than we do. Service economies are supposedly a higher level in the employment chain but a lot of it relies on wealth created in certain fields - mainly technology and scientific innovation. That's how any economy throughout time has become rich including ours (some economies have become rich from natural resources such as oil but this is unsustainable in the long run and the UK has very little resources). So surely we have been pumping lots of money and investment into the innovation and development of technology in this era of cheap money? In fact in reality this area has been shrinking just when our economy is going to need this field more and more. Less students are choosing science and maths related disciplines instead have been opting for Sports Science (P.E) or Media Studies (watching a particle accelerator - sorry we don’t do science any more - a TV). I could have picked a number of disciplines like the above two, in fact there are far worse disciplines than these currently taught in our educational institutions. One particular area of the economy that has been allowed to expand far too much is the financial sector. In reality bankers don’t create productive wealth they simply manage societies wealth generated through the productive trade. The financial sector should always be viewed a peripheral branch to the economy – not core to it, which is exactly the opposite of what has happened in our economy in recent years.

Now above I mentioned China the work engine of the world these days - although it applies to the whole Asian block, Vietnam, India etc. Mass amounts of capital have been pumped in to this region. So surely they have been going on cruises, buying the fancy cars on credit (debt) and probably have a BTL portfolio. No. Instead China has been wisely investing, yes investing, all this new found money on the economy, infrastructure and its people. They not only have huge manufacturing operations but are moving into the high tech economies and catching up fast. Google and Microsoft have recognised this and have set up centres there and guess what - more and more technical papers are being written there. Soon China won't just be making our goods - they will be designing them. China has witnessed double digit economic GDP growth in recent years whilst we have had 62 uninterrupted quarters of 'easy credit, debt fuelled' economic growth. Our GDP has been no more than 4% a year usually around 2-3%. When put into this context this is hardly a 'booming' economy. So while the Chinese have been investing their money in their economy, people and infrastructure what have we been doing with our new found 'wealth'. No not investing in the above, instead we have been buying and selling houses to each other for ever increasing values. It's complete madness. That’s not economic wealth. It's the same house. It's the cheap money that has pushed the value up not a solid economy. The recent house price rises are not predominantly based on the traditional GDP growth that raises land prices (it is not houses that rise as is commonly misconceived) as the economy has more money so can afford to pay more for land.

Our nation is now in the grips of a consumer culture, that's how our economy now functions. You just have to look at all the out of town shopping centers that have appeared in recent years, fueling our addiction to shopping, making it more convenient to spend money that hasn't actually been earned yet further fueling the debt bubble. People now actually put 'shopping' as a hobby on their CV's - this is the culture we have now descended into. Ever more keeping up with the Jones, delusional states of what people earn. We are materialistically brainwashed from an early age with a culture of recent youth 'I want it now' buy now, pay later.

So what will happen now? America has already chosen their course of action by trying to inflate their way out of trouble with 'Heli Ben' leading the cause, even though this has drawn criticism. This is due to the recent contraction of credit, which is exactly what happened during the great depression, so the Fed believes that it can increase the money supply by printing more cheap money, which is what has landed up in this current situation. The problem being this is what the Fed tried to do during the great depression they tried to inflate the monetary base however due to the crisis in confidence banks and individuals hoarded money and the money multiplier reduced so broad money continued to contract. The banks held higher reserves thus negating the Feds attempts to inflate. This is commonly known as the 'liquidity trap', even Greenspan, the previous Fed chairman said central banks have very little impact to negate these risks. What has happened during the past few years is that interest rates were too low for too long and private banks lent out too much on far too low lending reserve requirements, in short the damage is already done however the Fed will prop up these institutions thus the turmoil will linger for a longer period. I have noticed that the Government recently has brought in numerous regulations which is similar to what happened during the great depression, and it seems today that we are intent on repeating that very process. Global investors are warning of the economic turmoil ahead, from Marc Faber to George Soros who recently said it is the end of a 60 year boom.

The UK is more difficult to assess. Firstly the BOE has a remit on Inflation, so technically they shouldn't cut rates, however they are the flip-flop central bank at the moment so I feel cuts will probably be on the cards. I suspect they will use the deterioration in the markets as the excuse, the same as the FED but this will only worsen the process as detailed above, the liquidity trap. Economists generally agree that the best part of the business cycle is in the bust period. It removes all the excesses of the boom and restores the economy to its true optimum position. In a truly free market based on the Austrian school of economics, we would have a depression/recession. This will re balance our economy to address the problems described above, sooner rather than later and contrary to public opinion, would be effective by quickly addressing the issue that we don't have enough savings and we are far too much of a consumption based economy. We still have centuries of wealth in our economy, but this is not guaranteed to last forever as the points above should have outlined. It's like someone who wins the lottery, the money will run out at some point if all you do is shop, while as if you invest the money it will last for a longer period and be put to more effective use. With the emerging Asian Block of nations it has never been as important as now to invest in our education and industries. If we fail to do this we will witness a slow and gradual decline in our living standards as the recent 'wealth' has not been gained by productive labour. In fact I think we have already seen a decline in our living standards - technology and cheep foreign imports have just masked that. Typically both parents have to work to pay the bills - this can be seen by Britain's rising unhappiness occurring at childhood. The point is technology should make life easier and better, I could list many other issues with society but that would be another topic.

I know a lot of people reading this may be disagree, ‘our economy is in great shape with sound fundamentals' they may say, but I urge you to re-read the quote given at the start of the article. All periods of history of rapid growth have always succumbed to a bust. This is no different.

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