Tuesday, 2 September 2008

Panic Intervention

"If you look at this situation, because we've got low inflation we can cut interest rates, because we've had low debt we can afford to keep our public spending programme in line and to borrow at the right time to help the economy come through difficult times."
Gordon Brown 8/4/2008

"The national budget must be balanced. The public debt must be reduced; the arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced, if the nation doesn't want to go bankrupt. People must again learn to work, instead of living on public assistance. "
Cicero, 55 BC

It seems that it is finally dawning on people that the UK is about to enter a recession. With zero growth reported for the last quarter the credit crunch is beginning to show up (as explained before due to statistical manipulation we will actually be in negative growth territory already due to hedonic and substitution manipulation of GDP data). Credit is being destroyed and all the bad loans are only just starting to surface with rising arrears in the UK banks. Job losses are starting to gain momentum and will keep rising over the coming years.

When faced with a deteriorating economy the best thing the government and institutions can do is nothing. Of course this would not be a popular policy with people so politicians always do the exact opposite. This was mentioned in the previous posts and I'm afraid this will prolong the economic misery and draw out the crisis further. America will probably nationalise fannie and freddie mac, huge institutions in the mortgage market across the pond. This is a disaster and the FED seem intent on propping up and monetarise this bad debt (which in the long run will result in further inflation). The UK it seems is now proceeding to carry out similar policies by cutting stamp duty and support bad debt. The Tories suspended stamp duty in the last recession, and they openly admitted after that it had done more harm then good, and cost hundreds of millions of pounds.

Gordon Browns popularity is at record lows in all the polls, and he is constantly being questioned on his leadership so it is no surprise that for his own political goals he wants to try prop up the housing market and be seen to be doing something. This is the politically popular thing to do, however this will be a disaster in the medium to long term for the UK. They have already nationalised Northern Rock, with a lot of bad debts, which again will cause pain for the UK in the long run. By trying to artificially inflate a flagging market, it will take longer for the required adjustments to take place and more pain and monetary inflation for the average person. And why prop up house prices? It diverts money away from productive enterprises into a sector that is priced based on the surplus that the productive economy produces. What we should be doing is letting this bad debt get written off and more importantly letting the banks deal with the handling of this. You don't see the government deciding to subsidise the IT industry when the dot com bubble burst as most businesses that collapsed were running unsustainable business models. Business models where start up IT companies had no earnings. Similar to buy to let landlords who are subsidising rents in the hope of capital gains. A unsustainable model. A free market economy should be left to its own devices.

Of course the reason institutions are beginning to prop up companies and monetarise debt, is the credit boom we have just witnessed has been the largest in history and has been allowed to go on for too long and inflate too much. I believe it is that big, that if the printing presses were not to be run then we would witness the collapse of the financial system. The deflation would be immense and there wouldn't be the money in the system to keep pay the existing debt created and the public would find out that the current system we operate in has been allowed to fail. Remember we have had inflation in the past decade, however this has not shown up in consumer goods that we purchase. It has gone into assets - stocks, houses and debt. Now however we have turned a corner and the credit expansion has begun to break down, under the weight of just paying the interest on the current debt. Therefore defaults occur and this debt which is based on future earnings, has to be effectively taken out of the current time frames monetary earnings. This is hugely destructive and why banks are getting Treasury Bills from central banks, to try and replenish the little capital that is available at this current time frame. Asia and places have also absorbed a lot of inflation for us, by buying up dollars and euros etc. However they are now beginning to want to diversify their holdings, interestingly into Gold. Of course they can't dump all their dollars onto the market at once. Take for example China who hold $1.5 trillion dollars, they want to move slowly out of the dollar, but can't immediately as this would cause a collapse in the dollar thus rendering their reserves worthless (also collapsing China's biggest customer). This will be an interesting area in the future, with a lot of pain for westerners. The Russians, Saudis and Japanese also holds huge dollar reserves which is one of the reasons America can have 2% interest rates, while inflation is running at around 4-5% (actually more like 8-9% using real inflation) - other nations are funding Americas consumption.

There has been a downturn in commodities recently as I said this will occur in the short run as there are always consolidations along the way. This will only be a temporary correction, and the prices of "stuff" will increase further in the long run. What will further support high prices is the fact that the FED are determined not to let deflation take hold, which means they prefer inflation for the economy. Ben Bernanke has already stated that under a fiat currency (which all western countries have) Central Banks can always inflate and print infinite amounts of money. Sounds a bit worrying? 1970's again? Stagflation? A prolonged period of deteriorating living standards for people, however a lot of the factors are now in worse shape than they were in seventies. Larger debts, decreasing wages, and the emergence of the BRIC nations (Brazil, Russia, India and China).

There are three options, in my opinion, that Central Banks and governments could choose to handle the current situation:

  • Default on the debts - would lead to currency collapse, and probably starvation and result in 3rd World Living standards as we import most things, so a collapsing currency would render our purchasing power obsolete. This is therefore not an option.

  • Deflation of the Credit Bubble - Leave the system to self correct. Credit would be destroyed, wages would drop but so too would prices of goods therefore offsetting drops in wages thus keeping purchasing power. The problem with this option is the debt of governments and individuals would increase in real terms as wages and government income drops. This is what happened during the Great Depression as money contracted, debt increased even without more debt being created. However the debts we have currently are a larger percentage of GDP then they were around 1932 - well into the Great Depression and after a couple of years of deflation. This will not be an option in my opinion as Western economies generally have huge amounts of external debts to other countries, in particular America (Also liabilities for the ageing of society). The debt would increase as would the interest payments on the debts, therefore could result in the above, default.

  • Inflation - Governments and Central Banks replace the credit being destroyed with new money, in effect trying to re inflate the bubble at all costs, thus causing inflation. This in effect erodes debt and ensures the debt mountain does not increase if the natural course of deflation was to take place (the above situation). Throughout recent history governments have always favoured inflation or known as the stealth inflation tax (as people are always confused as to who to blame for inflation and governments can blame others for monetary inflation) and have always intervened in markets. This option will prolong the crises for some time and cause incomes to be squeezed. The endgame will be deflation when the public become sick of inflation (hyperinflation in the worst case) and demand a return to sound currency and a stable money system. At this point the government have to contract the money supply and to ensure it has value (late 70's, early 80' double digit interest rates). I suggested this scenario in my previous post and all the facts available point to this outcome. However, what happens if the deflationary forces are too powerful? What happens if the central banks can't inflate? If people begin to hoard cash?

There are a lot of issues Western Economies will face over the coming years and the price of homes is not one of them. A return to sane price levels should be welcomed, as money and effort is required in more pressing areas of our country. It is not the job of society to bail out bad loans and irresponsible individuals (and bad government regulation of the fractional reserve banking system). Let businesses fail and prices adjust and then the government and system can be exposed for the flaws it contains and ensure the excesses do not occur during another boom. If it collapsed we could even discuss a possible replacement to the current financial system and replace it with a more stable and robust model that is more beneficial for the majority rather than the informed minority.

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