Saturday, 28 March 2009


"The banks are fucked, we're fucked, the country's fucked."
Anonymous Cabinet Minister speaking in regards to the UK

"The last time we built up this much debt was when we were fighting ... half of Europe. This time we've done it on our own. It's quite a chilling thought. This is my worry is that it's like the man in the casino has lost it all on red and you know ... what's to stop Gordon putting it all on red all over again?"
William Buiter ex MPC member on recent events

The first UK Gilt tremors were felt this week. It was the first failure to sell non-inflation linked (regular) government bonds since 1995, with only 93% coverage. Back in 1995 it was 99%, which shows the significance of this event. Comments made earlier in the week by Mervyn King, the Bank of England's Governor in regards to worrying levels of government debt and how he may not wish to print as much money as first anticipated spooked the market. So how significant is this event and what does it mean for Britain in general? Is this a sign of things to come for many Western Governments? Many commentators may dismiss what happened as a one off or just a fact of bond auctions, however this would be very naive. It would be correct to state that this is only one failed auction, however context is key. This is not 1995.

Estimates for the following years budget deficit has come in at around £150bn - £200bn, which for a small nation such as Britain is a huge amount of money that the government needs to raise. Along with the shrinking economy, with last quarters contraction revised to -1.6% GDP, giving an annualised figure greater than -6% GDP, these billions listed above could turn out to be even worse, as Britain begins the path towards bankruptcy. The fact that a Gilt auction has already failed this early on, and by such a large margin, should be of great worry. As mentioned before on the blog, the governments bond markets are a classic bubble as market forces are being tampered with, along with irrational investment behaviour. Will the Government let market forces burst the bubble now? I doubt it. Like all bubbles it will continue to grow, going against all market fundamentals.

The other day, bond yields went up as the government struggled to sell them. This is market pricing in supply and demand where there was a lack of demand, therefore the government has to raise its returns for potential investors in order to attract buyers. The market forces where yields go up should be allowed to happen. In the Euro zone recently there is now a large divergence on the returns given to hold say German bonds, to say Greek bonds. Greek bonds are now having to offer far higher returns to compensate for the fact that there is more risk in the country, specifically default. Despite what the Greeks may say regarding the Euro, or their wish to have control over monetary policy the current situation is actually beneficial to the Greek public. It ensures the Greek government can not print money to buy government debt, thus artificially reducing short term rates on government debts. This of course encourages the Government to take on more debt as they can print money, thus holds the rate of interest artificially low over the short term so they can increase spending thus piling up more debt. However there is a cost to all this. Specifically this is how massive inflation begins, by the governments spending getting out of control thus printing money to pay for it. If the Greeks still had the Drachma, this is what would happen leading to high inflation and in Greece's case probably currency destruction.

As they are on the Euro, they consequently don't have this control, rather it seems to be the more traditional hard money countries such as France and Germany that have greater control. German officials and the Bundesbank understand the problem, and they know printing money can not help along with huge government spending in the long run. These ECB hawks know we have to take the medicine now allowing market forces to work and ensure real capital is used for government debt, not this 'new' money. This is the problem Britain finds itself in now, however Britain has the pound so it can do what it likes unlike Greece. It still has full autonomy over the printing press. The recent lack of buyers now casts doubts over the governments ability to raise the £200bn or so in money over the next 12 months. And not only the next 12 months as Government deficits are going to be a feature for a very long time, even with huge spending cuts all the other governments debts that are yet to be felt will be coming into play over the next 5 - 10 years. So where does this leave the Government?

It has already embarked on the policy of QE, printing money to buy government Gilts with an initial figure of £150bn mentioned by Mervyn King to buy this debt, with statements when this policy was implemented that this figure could rise. So this is where we come onto how the Government always distorts the markets. The statement that they made sent a signal out to the market, "If there are no genuine buyers of government debt, then we will buy it". Hence the first market bond sale after this statement was made saw huge amounts of buyers with the auction being oversubscribed. The market is now playing the governments game, a game of the last one to hold the debt will get burned, and the market is thinking that will be the Government. In the future all Bonds will be bought by the Government, with all other sellers rushing to sell. It's a classic Ponzi scheme, where the whole pyramid exists on the premise of selling to the bigger fool.

Many nations are embarking on this path, America, Japan even the traditional hard money country Switzerland has followed this route. QE will just blow this bubble up further causing more damage in the long term, as this will become a vicious cycle if it is not stopped soon.

At the moment inflation is not a concern so the bond investor does not demand huge returns. With the Stock market in the tank, other assets falling in value and deflation on many peoples minds Government Bonds look like a good bet, a steady income stream 'sheltered' from the financial dislocations. Therefore people have piled into Gilts. However as government debts have been growing in certain nations, contracting economies and huge economic imbalances in these countries, market forces are trying to set higher returns, specifically for nations with these risks. However with the new intention for expanding the money supply to "combat" deflation, QE is now monetising many of these bonds, in effect creating artificial buyers. Similar to the recent housing bubble, real demand was never there, it was just people flipping houses to one another with artificial cheap money as the driver. The market anticipates this new QE artificial demand, by lowing rates as there is less risk on default as more buyers have entered the market - seemingly increased demand, limited supply. This is where the real trouble begins, the point we find ourselves in now. The UK money supply has actually been expanding over the past few months even more than during the credit boom, which is highly inflationary under an environment such as this. This will eventually feed through to the economy into consumer prices. With the currency devaluing (inflation) there is a decrease in the demand for bonds that are not inflation linked as the future becomes more uncertain. Usually under this environment yields would rise to attract buyers, however with the Government becoming increasingly strained just paying the interest payments (and with the fear of no buyers thus in effect bankrupting the government) they wish to try and keep these yields down. This in turn means the government has to buy more, creating more artificial demand. This in turn feeds back and increases the money supply, thus creating more inflation with investors demanding even higher returns of compensation. With the monetary base getting ever more out of control it leads to investors fleeing Gilts even more, thus eventually leading to no genuine buyers, with the only buyer being the Government. Such a cycle feeds back on itself, creating an even more desperate state of affairs, and worse economic conditions.

We are only in the early stages of the above. In theory, this could be stopped now with the Government abandoning QE, but I doubt it. Not with the huge deficits to come and the lack of Global Capital. The above describes the very process of how the Central Banks believe they can beat the market. However they can't, as the above details, they can only make it worse and the longer they try to 'beat' the market the worse they make the situation. In the event that things go to far they will destroy the currency, the lifeblood of the economy, thus impoverishing us all. Prices are there for a reason. Economists will tell you that when yields come down, that the Central Banks have saved us and proclaim that QE has worked. It can never work and is doomed to failure. The longer they try and hold the short term price down, the higher it will shoot up eventually and the longer it will stay there. Just like any market price, it's there for a reason - basic supply and demand. Kings new hard line will not stay for long. He will keep the QE program on track, with the initial £150bn just a foot in the door. There seems no political will to scale back Government spending or accept the terms of an IMF loan just yet.

The basic process described above is how all governments go broke. It begins with a little, but eventually takes over the whole market similar to Zimbabwe. With statements continually made that they will be able to "turn off the tap" or "mop up the excess", this is simply not true and misleading for many members of the public. Countries like Ireland, Italy, Greece etc may complain with the hard line the Germans have took, but they are doing them a favour in the long run, some tough love. We may well see the EU take exactly the same route described above, I do not discount that. However at least we have witnessed some rational opinions expressed again by the Germans, many whose Great Grandparents and Grandparents lived during the Hyper-inflationary Weimar period. The UK should let their Gilt Prices rise. This puts a check on excessive government spending by the market rationalising on who is solvent and which countries are sound. If there are no buyers, let there be no buyers. This will either stop government spending altogether or let the country go bankrupt. The short term pain would be far better than bankruptcy by the printing press, drawing out the process and leading to a much worse collapse.

The Currency Wars

A new world currency? Russia and China have expressed their recent concern over the Dollar monopoly of reserve status and have mentioned the possibility of an alternative, not associated with any nation - a new world currency. The Austrian School of economics predicted this back in the 1960's, along with the creation of a European Common currency that would supersede this step. We saw the Euros creation back in 1999, are we about to witness the early stages of the Global Currency? The Austrians said this would be the ultimate desire of Governments, the ability to inflate with no apparent currency fluctuations occurring masking the debasement. Timothy Geitner put his foot in it, and contradicted Obama by saying it would be a good idea. The Euro will probably fragment at some point in the future. Nations such as Greece may opt out, thus regaining their autonomy over their currency with the ability to inflate once more. We will have to see. Back around six months ago I said currencies will disappear or merge, with the Icelandic Krona the first victim, there will no doubt be many other interesting twists and turns over the coming decade.

More Carry trades will continue unwinding over the year. The Yen carry trade that we witnessed unwind last year, causing the collapse of the Icelandic Krona, the fall in the British Pound and the spectacular rise of the Yen, should still unwind some more this year, as more of these currencies come under pressure along with the increasing scramble for cash. The Eastern European Debts have been unwinding too, with these debts bought in Euros, Yen or Swiss Francs beginning to undo as the hryvnya, Forint or Zloty have devalued. There will be lots of civil unrest to come in these countries, Latvia and the Ukraine will not be the last to succumb to protests. We will continue to see more gyrations of the worlds currencies, as "beggar thy neighbour" policies continue and carry trades continue to unwind.


  1. christian pickett25 May 2009 at 04:26

    "This is where the real trouble begins, the point we find ourselves in now. The UK money supply has actually been expanding over the past few months even more than during the credit boom, which is highly inflationary under an environment such as this. This will eventually feed through to the economy into consumer prices."

    banks are cutting their do you suppose a increase in money kept at central bank reserves (like in the USA) is highly inflationary when lending (the fractional reserve muliplier effect) is not going to be occuring until the debt is restructured ....leaving credible borrowers.....not to mention banks will be needing a ever increasing stash of cash as loan losses mount ...........I do not see any mechanism for inflation getting into prices (with unemployment high...wages stagnant....banks not lending) no matter how much banks buy debt.....I see this logic (inflation is inevitable from monetization) time and time again and i don't see how the money gets into the real economy when we have high unemployment high levels of debt wage stagnation.......debt restructuring must occur before any inflation does! so will this be from large scale bankruptcy's or jubilees' with perhaps a (consolidation of power) or a one time devaluation (perhaps co-ordinated) because that is the only way i see debts being serviced by otherwise stagnant income and high unemployment....

  2. Chistian,

    See my comments in the export/creditor nation post. The answers should be in there.

    Deleveraging is temporary, while as the printing we see can go on forever. Income levels, unemployment is all irrelevant for inflation - its more money with the same amount of goods or services.