The Fallacies of Deflation

It seems every authoritative figure has begun warning about the dangers of deflation. With Britain's Monetary committee making a case for printing money, we are told that this is to ward off the 'dangers' of a falling money supply, and we need to inject more cash into the system to get the economy moving again. The Keynesian's, the governments economic cheerleaders, are proposing that inflation is needed in order to combat deflation and the new money can ensure increased consumption in order to drive the economy forward. Deflation is one of the most misconceived economic terms, used as a scapegoat by the above institutions portrayed that it can somehow cripple an economy. Yet Deflation should always be embraced as it is a sign of a healthy free market economy. If our economic system was truly free, we would never get inflation. We would always have deflation in the modern sense of falling prices. However Banks and Governments always prosper with inflation. Throughout history this has been demonstrated with the costs borne by the rest of us. I felt this post was needed as I have become weary of these statements that deflation is some how a terrible event that should be avoided at all costs, used to try and justify printing money. Nothing can ever justify printing money or inflation and this post attempts to tackle these common misconceptions that have been indoctrinated onto the public, either by officials and economists that prosper from such policies or are incompetent to see what is happening.

Credit Expansion, Banks and Governments

Governments worship inflation. It funds their expensive welfare programs. It funds their wasteful consumption. It funds their political ideologies, their Utopian society they promise the public who elect them. Permanent inflation, like the one we have in our monetary system would never occur in a stable and free market monetary system. It can only occur by the continual expansion of our money supply. Markets always reduce the costs of goods ensuring greater productivity efficiencies as capital is used to enhance the way we make products. The debasement occurs with the co-operation between the banks and the state, similar to what we are seeing now. There is no conspiracy behind this as there is a long history of governments encouraging reckless credit expansion from the banks. A credit boom, like the one we have just come out of, creates huge amounts of credit which is spent during the boom. Most of this money does not exist as fractional reserve lending allows banks to lend far more money than they hold on deposit (money that actually exists). The government allows this privilege to banks as it inflates the currency, expanding the amount of money in the system. Despite the huge deflation we have had over the past 10 years in, computers, mobile phones, holidays, with all these items coming down in price, we have still had continual inflation. That inflation was a credit boom created by the private banks orchestrated by the central banks who prop up this credit expansion process, ensuring it goes on for far longer then would occur in a free market system.

At some point this process breaks down (a credit crunch), usually by previous investments turning bad (sub prime was the trigger recently) thus wiping out what little reserves the banks have. The banks reach a point where they can no longer inflate and central banks become the lender of last resort propping up these banks, and essentially printing money to replace the credit being destroyed. This is the current time frame we find ourselves in. Deflation, as in a contracting money supply is happening, thus the government and institutions step in to inflate. Since the credit crunch began true deflation has not actually occurred. Instead the money supply (Broad Money, M3, M4) is still growing as the governments resort to running huge budget deficits, that will be paid by printing money. We are told that this is necessary, as our economy needs the credit in order for it to operate. This however is not the case.

It doesn't matter how much money you have in the economy, so long as it is stable and divisible enough to price goods and services. Zimbabwe has huge amounts of money, yet they are no better off than traditional hard money countries such as Switzerland. In other words our prosperity does not depend on how much money there is, only that it be a commodity that can retain its value. If we allowed our money supply to drop, as markets are currently indicating, prices would just fall to a new equilibrium. If our money supply fell 50% then prices would generally fall 50%. This is the way to get out of the economic hardship we find ourselves in. This ensures a healthy liquidation process runs its course and cleans out these excessive speculative debts, those of the wasteful businesses and individuals. It would also stop government spending, and these unpayable deficits that we now see. It would be painful, depending on your circumstances, but it was brought about by the excessive credit expansion of the previous boom. The market is simply trying to get rid of these excesses. The worst thing we can do is try to re-inflate like we are currently doing. History has always shown this, and economic theory proves it.

Deflation is Compatible with Economic Growth

The recent credit bubble has now morphed into a violent contraction as the credit expansion process has turned into a credit contraction. This is not to be confused with normal market deflation (constantly falling prices), rather a by product of the elasticity of our money. In a free market that did not permit excess credit creation (ideally none), used sound money and removed the monopoly our governments hold on our money, deflation would be a normal occurrence. As history has shown, economies that have undergone deflation, have performed better than economies that have experienced inflation. Milton Friedman, who in fact believed in price stability therefore inflation, concluded that America during the period from 1865 to 1879 experienced huge economic growth despite having no inflation. On the contrary the U.S. was experiencing deflation.

"[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. . . . [T]heir coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible."
Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867–1960

Around this time Germany also experienced rapid price declines, yet had the best economic growth in the whole of Europe as they became a world superpower that challenged Britain's status at the start of the twentieth century.

These false justifications to create more credit will ruin market forces for years to come. Credit merely channels societies resources. If we have less credit then prices drop to their new equilibrium. Just because credit contracts, doesn't mean we suddenly loose all our infrastructure, our skills, our resources? They are still there, and will just be re-priced accordingly. The competent, people and businesses who did not overextend themselves during the credit boom, did not make wasteful purchases, will take over from the people who were overextended and have been liquidated, who could not manage societies scarce resources.

'Price Stability'

So why do we have this catastrophic credit expansion that creates all the issues we now have? Governments and Central banks use a concept of price stability. Many of you would have heard of it before. In the UK for example we have a composite index that represents typical consumer goods, called the CPI (Consumer Prices Index). The government (Central Bank) try to keep this target in a range of 2-3%. Around the turn of the Twentieth Century a proponent of this concept was an economist called Irving Fischer (an early day monetarist). The concept goes that this will somehow ensure greater economic productivity and planning. Another economist at the time, Friedrich Hayek, indicated that this proposal was doomed from the start. In order to stabilise prices in a free market where prices were continually falling, the stabilisation would inevitably take the form of a credit expansion, which would provoke a boom. This boom would be unsustainable and would result in these artificial credit distortions eventually unwinding with a bust.

These polices were used during the 1920's in America, with the Federal Chairman Benjamin Strong, ensuring 'price stability' by crediting a huge credit bubble in the stock market. Irving Fischer, who supported such polices said in 1929;

"Stocks have reached what looks like a permanently high plateau."

He also made statements for the continuing years that stock prices seem to have stabilised, even as they continued to decline until 1933. Meanwhile in 1928/1929 Friedrich Hayek, had wrote that a great depression was coming. Price Stability was a form of central planning, targeting fixed metrics that were incompatible with market forces. It was central planning intervention, interference with markets just like Communist Russia. At the time he was laughed at, people were saying it could never happen, this was the "Global Economy", the "New Economy". However the disaster was always on the cards, it was just a matter of time. Governments and Central Banks subsequently use 'Price Stability' to legitimise this expansion of the money supply that always brings about the boom and bust process we are currently seeing.

Price Indexes

Then we come to the point of the price index (CPI, RPI etc). How do we determine the algorithm to use? In a free society how do we decide what people spend their money on? Well one cost would be living costs, as we all have to live somewhere. Not in CPI. CPI, the preferred measure the government uses doesn't even include typically peoples biggest cost, their roof over their head. So how can they target 'price stability' when we don't include house costs. Quite simply they can't and its all an illusion. All the inflation went into houses - trillions of it, now its all spilling out as the governments try and replace the bad loans that were lent on these assets. It's a similar story with stock markets, they are also not included in any measure. The indexes they use from the start are flawed. Its all deliberate, to give people the illusion of prosperity i.e. rising asset prices to ensure continual inflation, debasement of our money. These are the justifications they now use for printing money, flawed centrally planned metrics which is just the same as any Communist centrally planned ethos. All monopolies are doomed to fail and impoverish the people. This is no different.

The amusing thing with CPI in the UK, is it hasn't even fallen in it's targeted range and yet the government are already wanting to print money, even before true falling prices have actually met their bounds that they use.

Arguments against deflation

There are many common horror stories with deflation, a fear is installed in people with various doomsday scenarios that will occur, and all of them incorrect.

The first one, is no one will buy anything. People will stop consuming and we will all have no jobs. So when mobile phones, computers, televisions, holidays, cars etc have all been falling, did people prospone their consumption? Of course they didn't, people have a time preference to enjoy their life now. Everyone knew these goods would most probably fall in price over the past 10 years yet everyone kept buying them at record levels for the enjoyment of these products now. People buy mobile phones every year, despite them continually falling in value. Common sense says people always spend money. We always need goods. People use these justifications for houses, if prices keep falling then no one will buy them. People will always buy houses regardless, as its a home, and people will always pay for the enjoyment of 'their' home. If peoples past expectation during the housing bubble was rising appreciation, then these attitudes need to change. A house is a home and historically has been a poor investment. When the credit crunch began people stopped buying homes not because they thought they would fall, but because the banks stopped reckless lending. Now people are not even sure if they will have a job, so buying a home suddenly seems like a liability.

Second, it would be harder to service our debts. Sure, if you have a million pound house with an income on minimum wage and a 125% mortgage. This only occurs in the extreme case we find ourselves in now, that is caused not by deflation, but the excessive credit expansion of the preceding years, all in the name of 'price stability'. Even in our current situation, people who have over extended themselves get liquidated. The people who have been prudent and competent take over these assets. Governments cut their wasteful spending, and don't rob the people through inflation allowing the competent private sector companies to take over - not the government like we are seeing now. An attempt to re-inflate will only result in further struggles to pay debts as the new money ends up in food, energy etc meanwhile production is distorted and hampered by these re-inflationary tactics.

Third, we will get a deflationary collapse like Japan in the nineties. It wasn't the deflation that killed Japan, as in a monetary trap, it was the government, a structural trap. It continued with further inflation. The government expanded its involvement, tried to prop up prices and didn't allow liquidation. The funny thing is U.S. Treasury Secretary Timothy Geithner now states that Japan did not inflate enough and that's why their economy never recovered. Talk about clown school economics. I couldn't believe what I was hearing. It was like Robert Mugabe stating that Zimbabwe's economy is in such a bad state, because he didn't print enough money.

Deflation allows all sections of society to prosper. It distributes lower priced goods and services to all income groups, regardless of social standing or what assets they hold. Inflation enriches the wealthy at the expense of the poor. It puts a break on social mobility. Banks and Governments are always the winners as they receive the money first. As the money moves out, prices rise and the last to get it suffer. As long as the government holds a monopoly on our money they will always inflate, regardless of the consequences. Regardless of robbing the very people they are elected to represent. The only way to prevent this is by giving production of money back to the people - to the market. Just like any other good, Chicken, Shoes, Phones, all are provided by the market and money is no different. It is merely a convenient commodity to exchange our more cumbersome goods. Britain had free market money around the turn of the nineteenth century, as it rose to become the economic superpower of the world. Government intervention outlawed it, as there was no benefit for them subsequently creating the modern money monopoly they still hold. One day, I hope we will look back at inflation as an ancient cult, extinct, with deflation a permanent feature in our economic landscape, discriminating against no social group and ensuring everyone can enjoy the fruits of a true free market.

"Today everybody is prepared to consider a rise in his nominal or monetary income as an improvement to his material well being. People’s attention is directed more toward the rise in nominal wage rates and the money equivalent of wealth than to the increase in the supply of commodities. In a world of rising purchasing power for the monetary unit they would concern themselves more with the fall in living costs. This would bring into clearer relief the fact that economic progress consists primarily in making the amenities of life more easily accessible."
Ludwig Von Mises, Human Action

Rick Santelli - Now theres an Idea

At least someone is speaking up for people who still believe in Individualism and the responsibility for ones actions. A new Brain Drain over the next 5, 10, 15 years? If these policies continue, I think so.

The Global Race to the Bottom

Since the financial carnage during late 2008, the real effects of the credit crunch have now started to be fully felt with members of the public now under no illusion of the severity of the situation the world finds itself in. No country has been isolated. The question is, how much worse can it get? Is the world heading towards a path of destruction?

Consumption based economies, resource rich nations, export driven countries - all have been hit hard by the turbulent events we find ourselves in. Since the collapse in commodity prices, after the huge de-leveraging that began in September last year, resource rich nations have come under intense pressure. The Rubble is in dire shape as Russia's Oil and Gas revenues have dried up. Run under a corrupt political system that is trying to keep together its fragmented collection of states by use of oppressive force which now seems unsustainable in the long run. Mexico, whose low cost manufacturing operations have been hollowed out in recent years by the lower Chinese labor costs, has been heavily reliant on it's Oil revenues, however production has been in decline for a good number of years. Along with the collapse in Oil's price, the nations stability has become questionable. The Peso has slid to record lows recently, with the Central Bank trying to stop the slide. Markets always have more money then Central Banks, however authorities always like to waste money to try and prop up their currency as though that changes fundamentals. It's remains to be seen if Venezuela can remain solvent with Oils new low price. Iran faces increasing fiscal pressures, along with other Middle Eastern states in an already unstable region of the world.

The Euro continues to mask the various problematic states that hide behind it. The Mediterranean nations and the Iberian Peninsula, Portugal, Spain, Greece and Italy all with a traditional weak work ethics and a short association with democracy, seem like they could once again fall under a Totalitarian dictatorship once more. Salazar, Franco, Mussolini or the "Junta" - we could well see a new generation of radical political movements. Germany's output has collapsed, as its export market has dried up. Eastern Europe's economic miracle after the break up of the Soviet empire is beginning to unravel. Latvia posted a 10.5% fall in GDP in the last quarter in 2008. After the IMF bailed out Hungary, the government are looking to cut government spending and balance the books further. Meanwhile in Ireland they have begun looking at cutting public pay, in order to keep the illusion of solvency for the time being.

After the surge in the Yen last year, as the unwinding of the Yen carry trade took its course, the BOJ will no doubt try and stem the rise by looking at measures to devalue, as its exports have fallen off a cliff. Many of the other Asian nations have not fared any better. China's exports have also collapsed, but so has their imports by a larger amount putting pressure on resource rich nations in the region such as Australia. China's creditor position, now as cash is king, is finally beginning to buy into the markets it will so desperately need when its rise as world superpower resumes. Layoffs in the urban cities continue to displace people back to the countryside, and its not just China where layoffs are occurring in Asia. Taiwan, South Korea, Vietnam all of these export based nations are suffering.

Back in the UK, Ed Balls, Gordon Browns trusted advisor and friend who recommended granting the BOE independence back when Labour came to power, stated recently that this was the worst financial crisis in 100 years. He also mentioned we could see a rise in extreme right wing politics as unemployment increases. Just like the 1930's another crisis in "Capitalism" has arrived, with worldwide contraction occurring once more. Once more the same mistakes are being committed. The Krona collapsed last year, however this won't be the last currency collapse of the crisis, or for years to come. There will be more that come under pressure. The Forint, Rubble, Dollar, Pound or Euro - no paper currency will be immune to what is happening. Continual debasement will occur and further currency crisis seem inevitable as a race to the bottom takes place.

The US are leading the world with further bailout packages. Obama's recent stimulus plan will soon be in the system. Who will pay for it? Who will pay for the $1Trillion and growing budget deficit? Domestic citizens? Foreigners? In the climate we find ourselves in? Recent losses have been announced at the recently formed giant UK banking group Lloyd's. More pain is yet to come, along with further nationalisation of the UK banking sector. In a post I wrote just before the globe came close to financial collapse, I said there will be a limit to how much Governments will prop up institutions and infuse money into the system. Well it looks like I was wrong on that point as most governments are more incompetent than I gave them credit for.

The 'Fear' Index

Since the Credit Crunch began around 18 months ago, we have seen great volatility in the stock markets and the currency markets. One measure that is used to measure volatility in the S&P 500 stock index is the VIX index, the volatility index, which the below chart illustrates.


The parabolic move, that can be seen in September/October of last year shows how distressed the financial markets became during this period. If we look at the blue line in the middle graph (the 50 day moving average of the index) we can see it has steadily been rising from a low of 0 in October 2007 (Just after the Credit Crunch began), to around 35 currently. Its been on a downtrend for the past couple of months, so does that mean the worst is behind us? Far from it. We are just starting the Bull market in market volatility as the graph illustrates, with further, and in my opinion greater shocks to come. A recent downtrend has emerged but for how long? The Western stock market will not be a place to be for at least the next decade in my opinion. The bailouts, money printing, increased government intervention, currency instability and record low interest rates will ruin the free markets price mechanism and further flatten the production structure. These destructive effects are yet to be felt.

So who will suffer the Worst and who will lead the upturn when it comes?

We are not going to see an upturn in 2009. That's for sure. The exporting giants, such as China, Germany and Japan will suffer a great deal, indeed China should fall into a serve depression if it allows markets to work their magic (I mentioned back in May that this should be expected). Germany and Japan should follow similar fates. In fact nations similar to this will experience as bad downturns if not worse than consumption based nations such as the UK and the US. But some of these nations should lead the world economy out of the downturn when the markets have cleared, along with resource rich nations such as Canada as people will always need materials. They already have the productive capacity or resources when the recovery arrives. The key thing is that they let their domestic markets clear. As Japan illustrated this is not always the case. China will no doubt experience shocks and inevitable set backs (just as the US did back at the turn of the Twentieth Century with the panic of 1907, or the UK did at the turn of the Nineteenth Century with the wars with France), but their leaders are about as Communist as Adam Smith, and have a long term outlook to supplant America as the economic superpower. They are not concerned with short termism, polls, or quarterly GDP figures. They are concerned about building a productive capacity, and becoming the economic engine of the globe. 600 years ago China was the largest economy in the world under the Ming Dynasty. There's no reason why it can't be again. The other Asian giant, India, may well suffer from their larger public sector debt than other countries in the region. For all India's progress, there are still great issues there, whether it is their poor infrastructure (bad roads, frequent power cuts) or the caste system, I still see great potential but it will be limited by these factors.

Nations similar to the UK and US, who have used up most of their natural resources, are running huge deficits, have lost all thrift and have lived on a mirage of debt and cheap goods will be the slowest to recover. Many Western Countries belong in this category. Countries like Italy and Greece, with greater life expectancy, will suffer even worse fates as their vast public sector debt will no doubt drown out any possible recovery. Nations such as Germany may well be hampered by nations such as these as they try to hold the Euro together.

After the fall of the Roman empire, European culture went backwards not forwards. It slipped into what is now known as the dark ages, as the Islamic nations along with the Orient, became the cultural centers of the world, producing goods that fascinated the outmoded Europeans. It wasn't until the fourteenth century that the Renaissance began in Europe, with cities such as Florence and Venice importing goods and ideas from the Orient and the Middle East. The conquests of the Islamic Moors on the Southern Iberian Peninsula further dispensed wisdom and knowledge that spread slowly throughout Europe. The Occident, or what we now refer to as the West, began a long transformation, increasing their material wealth and ideas. Once again, Eurasia finds itself in what seems like a similar junction. Ideas, knowledge and culture are flowing in the reverse, from West to East. In the past it took centuries. This process may well take decades, as technology has increased the ease and speed at which ideas can be spread. The race to the bottom has begun, but who will be the first to resume the race to the top when the recovery arrives?

To fight and conquer in all your battles is not supreme excellence; supreme excellence consists in breaking the enemy's resistance without fighting.
Sun Tzu, The Art of War

By nature, men are nearly alike; by practice, they get to be wide apart.
Confucius, The Confucian Analects

Insolvent UK Banks

I'm amazed it was only 60% who said the UK banks were insolvent.

Soviet Britain

The past week has seen the inevitable short term rally in the pound, with it back up to $1.48 as I write. Regardless of short term market moves the UK economy seems to be moving dangerously towards the economic left, with government suddenly being the solution to market failure. When times are good every ones a Capitalist, but when harder times are felt, everyone suddenly finds that inner Marx. State spending is increasing with greater swathes of the UK economy being incorporated into the state. It's getting nearly as bad as the former Soviet satellite countries. There have been suggestions of a peoples bank. Whats the point? The Government already owns most of the private sector banks. Suggestions of a 3-day week have been mentioned, as though we should keep people employed in sectors where there is a lack of work to do. Strikes are back, marking the renewal of class antagonisms. The IMF has warned that the UK will face the worst recession since the Great Depression, with contraction the largest of the developed nations. British manufacturing is declining at a worrying rate, with the balance of payments going from bad to terrible. Even with our imports shrinking our exports are declining at a quicker pace, making the deficits larger. The Governments budget deficit for this year is already around £100bn and lord knows what it will be when its all added up at the end of the financial year. Still the Halifax housing stats were on up this month so we all best buy a house before the next housing boom, as though they come around every other year.

The UK seems like one big sinking ship at the moment. In a previous post I mentioned if we begin drinking vodka and smoking cigars you know we really are in trouble. Well we are well and truly heading that way, so get worried. The markets are getting the jitters with these perilous policies, with gilt strikes becoming common discussion. The bond market is one big bubble, and like any bubble will find a pin and burst. Whether the yields on bonds have to rise in order to attract buyers or as the government becomes ever more desperate and broke just decides to print up the money remains to be seen. Either way, we haven't even got started into this credit crunch. The interest on the current government debt is already a great burden with low treasury rates, but imagine the costs with double digit interest rates.

The printing of money is mentioned on the news bulletins, as though this was a sound economic theory, one in which will help us out of this mess. A belief that we can print our way to prosperity. On that account Zimbabwe must currently be the most prosperous country on the planet, even if they are slowly abandoning their currency. 'Economists' are defending these actions with statements that the central banks don't like to refer to it as printing money. Well what else is it?

A key concept in economics is unintended consequences, or secondary effects. With all the news of government bailouts it must seem like free money to people. I'm sure there are some deluded individuals who actually think the government keeps a nice pot of money that it can spend when it needs. In reality this isn't the governments money, this our future earnings, our money, our children's future. Its not government bailouts, its public bailouts. When the government spends or increases its debt, it in turn takes capital from the private sector. It crowds out the private sector by consuming scarce capital for bonds, instead of this capital being used for productive investment in the private sector. The more the government borrows, the more of a burden it is on the private sector and the more it crowds out free markets. In other words we get less bangs for our bucks, which causes further stagnation as inefficient government expands along with keeping broken business models afloat at the expense of good business. There's also the issue whereby more of our government debt is being bought by foreigners, as we have little internal savings. Interest payments rather than remaining in our country get sucked out, meaning less surplus capital available for ourselves. It really does worry me how low our savings as a nation have been in recent times, and the lack of productive investments we make with it (in recent years whatever capital we had got put into housing - not a wealth producing industry).

Well at least the Bankers are still getting their bonus

This is to be expected, in my opinion. There's no incentive to not give out bonuses, as the government has ruined the markets various pricing mechanisms. What surprised me was an article written by Robert Preston, defending these recent bonus announcements. Here are some quotes from the article in question.

"So the fear of the bank's board is that if it were to pay no bonuses, tens of thousands of its employees would be demotivated and all its best bankers would quit to go to rivals."

Well this whole banking bailout saga is an immoral and a tragic reflection on the state of British society, but I will accept the current state of affairs for what they are for the sake of this article. The first statement regarding attrition of staff, well this is what businesses do when they are loosing money - they put pay on hold and try and bring up the natural attrition rate, thus avoiding expenses such as redundancy. When I worked for EDS, a large US IT Services Company, they employed this policy as they were working on wafer thin profit margins, so had to reduce their headcount. And guess what? The best staff left as they went to the market to search for other work. So let these 'financial wizards' leave, the same ones who helped cause the current rot. What banking rivals are taking on staff anyway? Financial engineering is going to be in decline for sometime, indeed it needs to shrink as it expanded disproportionately compared with the economy. I doubt many other financial firms will be recruiting.

"But we shouldn't forget that RBS is a complicated global business with more than £2000bn of assets."

Complicated? What business isn't these days. Whats complicated about what RBS has to do at the moment? It has to stop lending, increase retail deposits and sell off what it can get for these '£2000bn' of 'assets'. Of course we should read, were worth '£2000bn' and liabilities for the above.

"It would be in our interest, presumably, to sell our 70% stake back to the private sector for a profit one day - and that would be impossible unless RBS were perceived to be a commercial success."

It's that mention of profit again. Forget about profit, lets just try and get half the taxpayers money back and I would be happy. Profit is already near impossible unless the UK decides to become the next China. A culture change that takes generations.

"That leaves more than 176,000 staff across the world who've worked hard and generated valuable profits."

For one they should be happy they have their jobs. And who doesn't intend to go to work and do a good job or not work hard? No one gets up and says to themselves "You know what, I'm going to make sure I really do a bad job today and see how counterproductive I can be". We all work hard, but it doesn't mean we should get a bonus. A bonus is all about giving people an extra incentive to meet company targets. If the company makes a loss, then the company goes bust eventually. So staff can't get bonuses if the company can't make a profit to their shareholders. RBS should be bust, so it should be grateful it is still around.


It's damaging enough that the real productive economy is to be burdened with these huge bank bailouts, but giving bonuses is just rubbing salt in the wounds and sowing the seeds for further public discontent. Banking is a sideshow, a middle man, an intermediary, whatever you want to call it. It's job is to direct capital to the areas of the economy that needs it, therefore assisting the tuning of the markets pricing mechanism and directing productive investments. With this in place, the real economy can do its job and provide goods and services for us all generating wealth. Paying traders millions of pounds in bonuses to buy low and sell high is not how it's supposed to work. In a free market with sound money, it wouldn't work like that, but it's too late for that now. We are in a hole and need to stop digging.

Alternative to saving the banks

The question is what are the alternatives within the current system? What would happen if we let the banks fail? This is the other option that I have been suggesting and the answer is a lot of short term pain. First you have the question of what happens to savers money, how would the banks pay back the savers? The government cover up to £50,000 so a great deal of savers would be covered by this, however the value of the countries savings is another matter. In short the government would have to cover a large amount, but no different to say the banks liabilities they have decided to cover recently. Savers should always be covered first. Of course the reality is, the banks don't have your savings. If only a small fraction of savers went to take out their money, the banks actually wouldn't be able to pay. Like in any fractional reserve system, once the credit contraction process kicks in, its inevitable that the banks can't pay out so look for government and central bank support, or further lines of credit. Its the elasticity of our current monetary system. Just as it expands very rapidly during the inflationary boom, it can contract just as violently during the bust. People also can't pay back loans, which is destroying the real savings people have. This is being replaced by all these bank bailouts, robbing Peter to pay Paul, essentially one big fraud. If the banks did default on peoples savings like they did throughout history, maybe people would start to question our current system. Maybe the alternatives out there could begin to be seriously discussed and a more fair and stable system could take its place.

When the government decided to prop up the banking sector, beginning with the collapse of Northern Rock this immediately began distorting the market. Once the government guaranteed all Northern Rock deposits this gave the bank a monopolistic competitive advantage over the other banks. So the public began taking their money out of the other British banks, like RBS, HBOS etc and putting it into Northern Rock. With a quiet run on these other banks, they had to go to the government to get assistance, in which the government had already helped Northern Rock so why not the other banks. Therefore we find ourselves in a position where the government, or us the taxpayer has taken on the risk of all the banks junk assets, all through the original bailout. This is in turn has sent the signal out to external investors, who we have become incredibly reliant on in recent years, that the UK is insolvent.

If we did let the banks fail wouldn't this ruin the creditability of London as a 'financial center of the World'? Of course it would, but what do you think the world thinks at the moment? All the bailouts have done is bought time. It's not fixed anything. It draws out this mess, inflicting further costs on the real economy, as other economic sectors earnings are used just to prop up the insolvent banking system. In case you haven't noticed, its not getting any better, in fact we are just starting the defaults that are about to occur here in the UK. And there is a whole lot of bad debt out there.

A classic historic example of letting the banks fail and not fail is Japan. Before the great eighties bull run Japan had a serve recession, where the government let the market take control. Banks went bust, huge amounts of liquidation ensued and at the time it looked as if the economy was going to collapse. This cleared out all the excesses, all the bad business models and set the economy on a sound footing. The subsequent years saw one of the greatest bull markets in history. Japan during the eighties was turbo charged, exporting huge amounts of goods and ideas, becoming a technological and business process leader. In films such as Back to the Future II, the future was portrayed as Americans working for Japanese firms, as their dominance looked inevitable. Then the 89'/90' bust set in. Rather than letting the market clear the excesses, the government decided to prop everything up. It began government programs, spending huge amounts of money, crowding out private investment. The hallmark of huge government debt is still there in Japan today. House prices and stock prices are still down over half their price than two decades earlier. Japanese business stagnated during these years, known as the lost decade (however as time has passed its now become the lost two decades). The UK is now preventing the liquidation, propping up weak businesses and creating artificial interest rates thus preventing the market realignment of capital goods to consumer goods.

History is repeating itself. It always does. Just like all recent economic crises, laissez faire, free market economics will take the blame, as we enter the Blame Game. These socialist polices, as though the market is always inherently wrong, will again take hold. I'm not a doomer or a prophet of doom that thinks humanity is heading on a course of destruction. I do however pay attention to economics and history and understand what happens when nations embark on polices like the ones we are seeing now. People are still clinging to the past prosperity they had, believing that this crisis will turn around at the end of the year and we can enjoy another decade of imminent wealth that the baby boomers believe is their right. There is no free lunch. We will have to pay for the previous years of wasteful consumption for decades to come. I was bearish before the bailouts and interventions began, but now I can see clearly that its going to get a whole lot worse. How bad depends on if people wake up to what is really happening. In my Blame Game post back in June before all these bailouts happened I suggested we would embark towards stagnation. The final paragraph of that post seems to fit more and more as time goes on.

"The key to the success of our nation will depend on the next 5-10 years. If we play the blame game I feel our economy and many other western economies will become stagnant for a longer period then the usual length of an economic cycle. If however we all accept part of the stupidity that has gone on and decide to work, invest, open our minds and produce creative goods and ideas, we will see a newer improved nation. In my opinion however, our mind set has changed drastically over the past generation and old habits die hard - stagnation for a considerable time seems more likely as time goes on."
Blame Game

“Government cannot make man richer, but it can make him poorer”
Ludwig von Mises

“Manufacturing and commercial monopolies owe their origin not to a tendency imminent in a capitalist economy but to governmental interventionist policy directed against free trade and laissez faire.”
Ludwig von Mises