Bond Bubble

I have noticed there has been more interest over the past few years regarding Government Bond Rates. In many countries they are at historic lows, all time lows even. Interest rates in many countries have gone negative, whereby the rate of inflation is now higher than the rate of return in the bond. Its gone even spookier than that now. A rate of return economists thought was impossible has now happened, that is interest rates on bonds have actually turned negative in some countries. In Switzerland a 10+ year bond can be bought to actually have a minus rate of return. This has never been seen before. I first mentioned the bond bubble six years ago and its worth revisiting as it applies equally to where we are now:

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.... 

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.

Its a measure of the mess we find ourselves in that rates continue going so low, to lows that we once thought impossible. This is a once in a lifetime super bubble, one that we will tell our Children and Grandchildren about. To an inquiring mind, how and why have rates gone so low and what format will the aftermath take?

A number of reasons exist why bonds have gone so low, the main one however is QE. Its no coincidence that since the ECBs announcement to an extension of the QE program that rates have gone to all new time lows. QE is distorting prices of bonds by creating artificial buyers. The increase in demand causes prices to rise (when bonds interest rates fall, they go up in value as any existing holders can sell theirs on for a increased profit as they locked in higher rates) just like in any market. 

So we have Governments buying bonds but that still doesn't explain private buyers. Well, by law a number of financial institutions have to buy bonds. For example due to regulations set by the Government pension funds for example have to allocate a portion of their funds in Certain Government securities, regardless of the rate of return. How about banks or other buyers who are not forced? We still can't explain why they would buy a bond that will erode in value over time. Like any bubble it works on the premise of buying an asset for the belief it can be sold to a bigger fool.

When people were buying technology stocks in the late 90's, where a company had no dividend, no assets - in fact in some cases barely a business case. Still such companies were on paper worth billions. People bought the stocks not for fundamentals but for the belief they could sell them for a higher price than they bought them for. A similar prognosis back then to now causes this phenomenon; cheap money. Like technology stocks of the late 90's or real estate of the 00's, bonds are the new bubble in town. And just like real estate and the Technology stocks they will go pop. Central banks have made sure of that and when they do you need to stay well away.

How long have we got? I'm sure rates will still go lower, to lows we don't think is possible. However when rates go into long term upward trend Governments (or institutions the Government forces to be buyers) will be the only buyers in town turning the greatest bond bull market in history to the worst bear market. Currencies will gyrate with wild fluctuations. Inflation will go hand in hand with this. Markets will act in ways we have never seen before. Central Banks will provide small glimpses of the illusion that they have control but you can not contain a market price, it always breaks out in some form of spontaneous nature. Stocks and Real Estate will offer no protection. These assets generally go to new all time lows in real terms in such an environment. Precious Metals will once again resume their bull market run, going into a mania phase. CNBC and the such will have feature programs and stories of people getting rich by holding such assets, which incidentally is sure to be the next bubble once the bond market goes up in flames. 

The bond bubble. It may mean nothing to you now. It may mean nothing over the next few years. But in the coming decade however it will mean everything. So long as there exists centralised monopolistic control over money there will be bubbles. Reading what those bubbles will be can be the tricky part but once you can read histories rhythmic patterns the future is for all to see. Then its just a case of taking the correct actions, sit back; relax and watch history unfold.

Rationing is taking place in the UK

Do not underestimate the importance of prices in shaping our quality of life. Countries without them do not prosper. Prices are the key component which co-ordinate supply and demand in an unpredictable, ever changing world. Zero percent interest rates sound great to many, just like having a free bread policy or setting its price below the market level. As previously discussed, it can only lead to rationing which is occurring in the UK today with Mortgages. Its not just backward countries that can experience such a phenomenon.

Interest rates are prices. Unfortunately the government tries to set such prices, usually below the real market level. Well we may like to think that our society is above all that rationing nonsense but that's exactly what is happening in a developed Western country today. 

After the financial crash of 2008 the Government took out large stakes in many UK banks. It also propped up the financial system by slashing interest rates in an attempt to pump liquidity into the insolvent system. It did the job - the losses were stemmed and prices began recovering. The problem was bad assets were not liquidated. Bad loans that were made during the credit boom, again engineered by the Governments loose monetary policy by setting interest rates too low, are still present. These bad loans remain on the Banks books, and they know it. In order to cover against such bad loans (and ensure no more are made) banks they need to preserve capital in order to cover such shortfalls. Viewing housing as a dead duck, Banks demand borrowers to stump up larger deposits, deposits they know people can not afford. They are sitting on cheap money supplied by the Government at very low rates but are too aware of the poison within the system. 

A true free market would clear prices, drive savers interest rates up in order to meet the capital supply and demand imbalances while liquidating bad loans. Its similar to wheat shortages. Bread prices in such a situation would rise, forcing demand to tighten and directing economic resources to find new sources of wheat increasing the supply thus solving such market imbalances.

The free market can't do this with mortgages today. During the credit boom people were given 125% mortgages and interest only payment options. So long as the market went north, banks would have the required equity in a house if repossession was necessary. Now with prices falling Banks are driving up interest rates for people with less than a 25% deposit, the banks safety margin. If you wish to take out an interest only mortgage (which few banks offer) then they drive up rates to deter the buyer and cover the risk that less buffer would be created by the buyer. In these times you need at least a 10% deposit, even then the deals are few and sparse with rates on such products far above the Bank of England's base rate. The Bank of England's artificial interest rates keep the whole system in a zombie state, a la Japan. The commercial banks can access cheap money so existing borrowers with large capital can access it and savers have zero percent interest rates on their savings. There is no incentive to save, repair the capital shortage, as Central bank give out money for nothing. Why pay someone to save and accrue genuine capital when you can borrow from the Central bank for nothing (which incidentally is not real capital, it in fact erodes the value of genuine capital within society).

You can't escape the basic laws of supply and demand by artificially manipulating prices. 

As the market rations mortgages people believe we need further Government interference despite the fact that they caused the shortfall in the first instance. The Governments solution is to take taxpayers money and give it to first time buyers to meet the banks deposit demands. Of course this only makes matters worse. The Government merely diverts economic resources from more sustainable lines of production into the dead duck that is housing. It gives this to people who probably can't afford the house in the first place. It also is completely unfair as it becomes a lottery who wins this money. If further losses are incurred then it is the taxpayer that foots the bill thus creating a double negative.

The solution is to allow prices to do their job. Otherwise rationing is the option and that is the last thing we need.

Where is the deflation?

"The Chinese government is expecting its economy to expand around 8% of gross domestic product in 2011, same as in recent years, but it has raised its inflation target to around 4%, indicating Beijing isn't willing to sacrifice growth even though fighting inflation is a top priority.

State television reported the new numbers Tuesday, citing Zhang Ping, the head of the National Development and Reform Commission. Next year's inflation target is a full percentage point higher than this year's target of 3%."

News that China will raise its Inflation target

If you were to believe the experts it is deflation we have to fear. Its just round the corner. Its a battle we must win. A depression must be avoided which apparently is caused by deflation. In the real world people are seeing costs rising all the time. Not just in the West but in emerging economies also. The Chinese authorities have raised their inflation targeting metrics in order to keep their bubble, sorry growth, moving up. A rule of life is governments always bend the rules. Its sets them. Free markets allow people as individuals to set the rules. Participants mutually trade with one another under an amicable agreement. The state takes at will and by force. Inflation is one such example, it benefits no one in society in the long run, only the government over the short term.

The fact that the target has been moved upwards should not be a surprise. This is what's going to happen everywhere, across the globe. Here in the UK our Inflation has risen yet again. Its now been above the target for over a year now and what are the "inflation fighters" (that is Mervyn King and his MPC comrades) doing about it, Nada. Zilch. They have already raised their inflation targets, they just haven't told the unsuspecting public. There's more price increases in the pipeline:

The increase in VAT from 17.5% to 20% that will come into effect next month will be used to "mask" more extensive price rises according to accountants at KPMG.

They claim almost two thirds of retailers and consumer product manufacturers plan to increase their prices by more than the planned VAT hike in January.

Martin Scott from KPMG told the BBC why he believed retailers would raise prices by more than just the VAT hike next month.

All this inflation is causing Government bond prices to stay high. Well I say high, but we haven't seen anything yet. They will go double digit over the course of this state induced disaster. Double Digit may seem high in today's environment buts that's what you would have thought when Interest Rates were single digit back in the seventies. In the US they eventually went above 20%. Ouch!

Well at least the banks are ok now. They were small fry. We have moved on to more impressive bailouts like, err, countries? Ireland, Portugal - what about when Italy and Spain need assistance? They in turn get bailed out by Germany or France or even the UK. Hang on, aren't we bust also? Yep. Fractional reserve banking, fiat state monopoly money, you have to admire it. The Governments legalised ponzi scheme. No one has the money for any of these bailouts. Deflation will never happen because Governments know this would be the end and a collapse of the system. Therefore they will print money. They will raise inflation targets. They won't even tell people they are doing this. Oil is at record high once more. Just like with any unwarranted inflation, peoples living standards are falling. Prices rise and real wages don't keep pace. 

Through all the bailouts and enlightened interventions, nothing has been solved. Its worse than before the crunch. Its the quiet before the storm, just like prior to the market collapse of 2008. Everything was fine until it happened. That's the problem with economic collapse caused by government mismanagement. You can't predict it, you just know it will come. And when it comes its always too late to act. We won't hit bottom until the market is allowed to cleanse itself, but that isn't going to occur. Until then, just know that inflation will always be there, always rising, even when it may seem its not. Deflation is just the Governments smoke screen.

Britain, the Canary down the Western Coal Mine

"We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step."

Jim Callaghan - Speech at the Labour Party Conference, 28 September 1976

Gold prices had been on the rise for weeks, then all of a sudden fell back with a thud as we were told that only 11,000 jobs were lost in the US during November. Another Brown bounce in the polls left Cameron backtracking, austerity is so last month, instead 'growth' by government spending is now acceptable as policy is dictated by focus groups. The Middle Easts version of Las Vegas got a helping hand which was good news for many UK banks, however only a mere $80 Billion would have been at stake. Years ago it would have meant something, not today with Trillion dollar bailouts. China's vice governor at the peoples bank declared 'We must watch out for bubbles forming on certain assets, and be careful in those areas' referring to golds recent upward trajectory. Nice try, that deceit may wash with CNBC but those of us in the loop know full well that China would love to transfer much of their paper assets into hard assets such as Gold.

It's sometimes easy to forget what the average person thinks in relation to financial matters. Articles posted here are certainly not consistent with mainstream thinking. People are still on the same broken record, 'Buy a house now while prices are cheap before you get priced out', 'We are past the worst now and good times are ahead', 'The government will make a good profit for the taxpayers with the bank bailouts'. Ask people who read the financial sections of broadsheet newspapers about gold and you get told 'The price can go up as well as down' as though this is a unique quality that does not apply to other assets such as bonds, real estate or stocks. Indeed it is important to remember just what people are thinking, because you don't want to be on the same page as them. 'Repeat after me, Gold is a bubble, Central Banks can 'tame' markets, the sustainable recovery is here and there is no inflation! There is no spoon!' There's no analysis of the thunderstorm that is brewing in the distance.

So what about this Gold bubble then? People are right, however they are 5, 10, 15 years too early in calling it. People are buying the stuff because one day it will be a bubble as the Worlds Central Banks are busy blowing the next bubbles as I write. The currency and Government Bond bubbles will eventually burst causing mass inflation and creating the next bubble, commodities and precious metals. As Bernanke and Company try to assess how best to deal with bubbles, they fool the public as though these events are some mystical force that no one can control. I have a simple solution, how about stop printing so much money. We instead move from bubble to bubble, the Centrals banks policy after one pops is to inject further easy money into the system. Like some drunk who throws up after a bottle of vodka, 'I best have another to sort myself out'.

Could the US unemployment figures signal the turn with people getting back to work? Maybe in the short term, but I don't think this will be a long term trend. You have to remember governments everywhere are printing huge amounts of money and this is bound to give the so called 'prosperity' effect in the short term but it won't last, the free market hasn't healed. During the coming stagflation a lot of conventional indicators will seem to be healing when in fact the underlying fundamentals are deteriorating. For ten years after the credit crunch in 1973/74 the unemployment rate in the UK kept rising.

It didn't move up in a straight line, with periods of consolidation and even movements to the downside. When the correct path was taken it took years to fall. Numbered estimates in the news are useless, three million, four million, all have been given as figures for the short term, however no one can say for certain, all we do know is that history says it will keep rising over the long term.

For a developed country the British people sure do love their inflation. While many other nations inflation indices have plummeting like many a British Banks shares, the UK's inflation rate has remained remarkably 'sticky'. Whether its the appreciation of our assets, our rising incomes, our increased levels of debt or the fallacy that we believe the weak pound is good, we really do want to beat other nations in the race to the bottom. The yanks scream 'bloody murder' watching their beloved dollars debasement from the powers that be, not realising that one hundred years ago a British pound used to be worth $5. Anything you can do across the pond, we can do it much worse. Over the next decade I'm sure we will show the developed world what not to do. The problem I see is that British people want inflation. We want to see rising prices, we believe that this is a healthy state of affairs and will thus allow a greater level of leniency towards our policymakers compared with other nations when it comes to expansive monetary policy.

Will the BoE raise interest rates when the market forces their hand? Contrary to what people believe it is the market that controls long term interest rates. We may like to think of central banks under a paternalistic viewpoint, our saviours there to insulate us from financial destruction and chaos, to solve economic issues should they arise. Central bankers are just like their Communist Central Planning counterparts, eventually market forces get the better of them where eventually they follow the market, not set the tempo as they would have us all believe.

In order to understand how markets dictate prices such as interest rates its easier to compare the lowering of interest rates to say lowering the price of bread. If the government declared rather than liquidity not been easily accessible that the issue was now high bread prices, they therefore set forth a policy to fix the price lowering it below the market one. As suppliers begin making losses they shut down production, at the same time people consume more as they can purchase more of the product. Eventually the country runs out of bread with all stocks depleted. Rather than bite the bullet immediately the government would in all probability resort to rationing rather than admit the error of their ways with bread queues becoming a common occurrence. A black market may appear as people under their free will and against the governments law begin selling bread to one another for a price set by people, the marketplace. If however the government wishes to fix the state of affairs they must liberate the price once more, allowing the market to determine the price of production. As suppliers closed down long ago abandoning their supply networks it takes a short while for supply to meet demand once more. During this period the price of bread goes into the stratosphere as people bid up the cost of the present scarce bread. Eventually market forces will drive the cost down over time to a point of equilibrium.

How does bread relate to interest rates? Its the same principle. Governments can set the price low but eventually the market will force its hand to raise the price, with the price going into the stratosphere. This is why we had 18% interest rates when Thatcher tried to put things right, or when Paul Volker put US rates above 20%. The policy makers were just chasing the market, trying to reign in inflation which was driving the free markets interest rates haywire. During the 1973/74 credit crunch Central Banks had the same idea as now, that is they lowered interest rates in response to the recession, but the longer and lower you try to hold down these prices the higher and sharper they have to eventually rise as many an older reader will painfully remember.

The BoE could be forced to raise interest rates under a number of scenarios. They may have to raise rates if there is a currency crisis with the pound falling as investors flee. Like the bread situation above, they will put off the price liberation, instead they will put currency controls or limits on capital (like bread rationing) in order to try and provide a short term fix. Eventually the market beats them and they have to hike rates as over the long run a lack of foreign investment creates a less dynamic economy and higher inflation.

It could be forced to raise rates if inflation got out of hand with the free market demanding increased real rates of return to negate the depreciation of the currency. Even if central banks keep buying government debt at artificially low rates, private banks still lend to all of us, with this mortgage rates could rise for example. Its similar to what we see now, despite base rates at near zero average mortgage rates are far higher as the free market realises there are inflation risks over the medium to long term. They are also hedging against their potential losses as the government props them up.

However they could do none of the above. They could keep rates low, spurring on more inflation as the government can no longer afford increased rates on the ever expanding debt. They by pass the market and lend to individuals themselves at these rates. They print money directly to cover the shortfall in the various government payrolls. Currency collapse is ensured at this point as it becomes clear to all that its time to pack your suitcase. Marc Faber believes this is the conundrum America will face at some point in which its policymakers will not rise to challenge, instead they will shirk away from the correct action to take, opting for runaway inflation. At some point the stock market of such a country would be a screaming buy, just at the depths of the seemingly never ending hyperinflation when the average person has lost all confidence.

Could the UK be the Canary down the Western coal mine? There are many other nations with serious issues that have faced or will face issues sooner, but I wouldn't put them in the same tier as Britain, a nation who still has a recent innovative and industrious past. She could however, be the warning signal for many other Western nations that mass inflation and/or interest rate rises are just around the corner. Either option ain't pretty.

Japan a Deflation Death? - Nope Stagflation

Gordon Brown this week announced what can only be described as a car boot sale of UK PLC's bric-a-brac goods, an attempt to sooth markets regarding the budget deficit. Many of the items have been for sale before, but I'm sure the government in their current desperation will be willing to accept lower offers this time around. I agree with privatisation in getting the state out of our lives, but a student loan book and a crossing in Kent are hardly big ticket items, never mind the fact that they are assets that generate money. Thatcher sold the majority of the family silver during the eighties privatisation bonanza however contrary to common belief there's plenty more the state could sell. Institutions such as the NHS, education the road infrastructure and so forth could all be sold, but these are not politically palatable areas that the public can swallow, meaning they are off limits for any politician that doesn't want to ruin their career. The Prime Minister once more began another Keynesian rant stating that the Conservatives proposals would lead to the same problems experienced by Japan for the past two decades. The title 'Prudent Chancellor' seems ever more absurd as time goes on, his emphasis on yet more needless spending in an attempt to bankrupt the nation. It doesn't matter if its Americas Great Depression or the lost decade in Japan, economists, politicians and journalists all seem to draw the wrong conclusions. What Gordon Brown in fact proposes are the very same policies that were pursued during both periods above and resulted in stagnation. Japan didn't get ravaged by the 'dangers of deflation', it was instead a good old classic stagflation.

Many Keynesian economists are still baffled by Japan. Over the years, policy after policy has been proposed by their school of thought, all of which involve some form of government action, but time and time again they all seem to fail. The classic Keynesian rebuttal whenever these policies fail is "Well, the authorities didn't do enough". Just like they apparently didn't do enough during the Great Depression. Yet put forward the question regarding Americas 1920-21 Depression and all Keynesian theory goes out of the window. Here Warren Harding, Americas president at the time, cut government spending, cut taxes and in fact did very little during a time when the economy was contracting at an alarming rate with the measure of unemployment rising faster than during the subsequent Great Depression. Yet the economy with market forces in full control, liquidated unprofitable lines of production and subsequently America during the 1920's experienced one of the greatest economic booms in history. The unemployment rate came dramatically down in no time at all, without government spending to alleviate this process as we are now all told. Herbert Hoover, who was later to become Americas President during the next depression, unsurprisingly didn't agree with Harding's polices, a pre-cursor of what was to come. Don't mention any of this to the Keynesian's though, it will give them a real headache.

What did Japan do when their bubble burst? Cut taxes? Cut Government spending? Liquidate? They of course carried out the exact opposite. Their Government debt used to be as low as the UK's before its recent exponential trajectory however Japans now stands at 200% plus and keeps growing. They propped up their infamous zombie banks, crippling the pricing mechanism that is so vital for an economy to prosper. Increases in taxes will choke the economy as rising social costs increase. In order to assess what really happened we need to deal with the aspect of deflation, or what is currently assumed as the bogeyman to economic growth. Japan never entered a downward death spiral of prices, that consistently fell year on year, in fact the lowest their CPI hit during this time was -1%. During the mid-nineties it spiked back up to 2%. There was only around 6 years of official deflation during the two decades using the Governments metrics. What gave the impression of price deflation was in fact asset price deflation. Both real estate and stock prices completely collapsed and have not returned since, instead stagnating for years. The reason why they never recovered to their previous highs was exactly what the Government did, they took over and tried the command economy approach. Roads to nowhere, propping up banks that were insolvent, not allowing private enterprise to take over the means of production. Rather than money going into the private sector, Japanese savings that were accrued during their economic miracle were funneled into Government bonds, wasteful Government consumption. It was quite simply a classic stagflation, that is still ongoing.

The UK are now pursuing similar policies and will go into a long period of stagnation unless the current direction is reversed. However it is useful to try and make further sense of Japans situation during that time, compared with our own. When the crunch came for Japan they ran budget surpluses, had high domestic saving rates for years and were a creditor nation. The UK on the other hand has the complete opposite and relies heavily on overseas investors to buy our Government bonds. Japan only began to run double digit Government deficits eight years later. They were able to sell their bonds to domestic citizens. They were still obtaining plenty of foreign currency as they exported more than they imported. The UK has already printed in excess of 10% GDP to pay for the debts, is running a huge budget deficit only two years after the current financial crunch and for the past decade its citizens have had low savings rates.

So what does all the above mean? Quite simply the UK is in a much more highly inflationary situation that Japan was. Japan's government couldn't really print money until over 10 years later as a last resort due to there being ample savings to pay for the Government debt. Japans government created their budget deficit, the UK has a structural one in which politicians are notorious for not tackling the shortfall. While Japans significant industries, electronics and car manufacture, continued to grow with global demand, the UK's key revenue streams, finance and North Sea, are in decline.

Another key factor is if the Government Bond market is in a bull or bear market. During Japan's economic disaster the bond market was in a bull market. Interest rates kept falling, people still had faith in many paper financial assets. Since 1981/82 Government Bonds have been in a bull market however these things always move in cycles, typically we should be seeing the end to this trend at some point. 25 years plus is a good run and in the near future this will turn into a long, grinding bear market, we may have already crossed that point. In a bear market, interest rates on bonds rise, which means Governments have to increasingly spend more on interest payments, diverting money away from spending such as health or education. Recently the CEBR said interest rates will stay low for the foreseeable future during the first half of the next decade, however that would mean the bond bull market lasting for over three decades, a highly improbable situation.

History is always an important guide to future trends, however it is crucial to compare given contexts in their current time frame. I have seen articles recently stating that Britain had debts in excess of 200% of GDP after the Napoleonic wars, indeed I have mentioned it myself before, however this didn't count for much when the UK went broke in 1976 with debts as meager as 48% of GDP. In the prior scenario the UK was the global superpower but a much bigger factor was that the UK didn't have a Welfare State. There was little government expenditure, with the majority of taxes just going to pay off the debt as alternative expenses didn't exist. Contrast that with current Government spending in which the interest payments are now comparatively small along with a rainbow of other Governmental expenditure, we see how context is key. Somehow, within the time frame of 150 years, Britain had transformed itself from one of the leaders of laissez faire, into a nation that was almost turning Communist in 1976. An ever expansive state, a declining currency, an economy with little productive purpose, meant investors wouldn't lend the UK any more money, despite the debt being around a quarter the level than that of the early nineteenth century.

Japan recently has around the same debt as the UK did 200 years ago and is still able to pay for it. It's dangerous to compare Britain with Japan, as Britain will not be able to sustain a public debt level that high. Japan built this debt up during a bull market in Government bonds and had savings to pay for it. The UK doesn't have either of those luxuries. It's one of the key concepts that many forecasters and economic commentators overlook, the fact that interest rates can rise over time and enter bear and bull markets. Payments for the interest are already predicted to soar as the debt increases based on the current low rates, but what about if those rates double 10 years from now? The government admits the earliest they can balance the books is around then therefore debt is almost certain to keep going up.

Do not believe predictions regarding long term interest rates and the level of debt a country can absorb, no one can forecast precise figures in these areas. Instead look at the fundamentals. Are the government balancing the books? Has the printing press been shut down? Has liquidation occurred? Until fundamentals return then stagflation looks the most likely outcome here in the UK. Just like Japan, only I fear much worse.

Interest Rates are Prices

A while back I posted on Interest Rates and Capital using explanations of supply and demand. It was to my astonishment that I noticed an article published by a popular newspaper. Rather then heap praise on the recent lowering of interest rates and accepting at face value what the central bankers were saying, it actually challenged these concepts and the so called 'wise men'. There is no logic to having a centralised committee setting prices such as interest rates. Rather than determined by the market these prices are adjusted by these central institutions. Despite all the propaganda that central banks are now 'Independent' its still the same as when politicians have control over interest rates. They always try to keep them as low as possible for as long as possible. Creating inflationary booms is the best weapon politicians have at creating artificial prosperity. Until the public balks at the inflation or the scale of malinvestment becomes too large, then these prices are risen by the powers that be.

A good question would be, how should interest rates be set? Who would set them if Central Banks were not in control? That simple micro-economic concept called supply and demand would set it. The great Austrian economist Eugen von Bohm-Bawerk noted that the setting of interest rates is a time preference, peoples preference to get money upfront in the current time frame. Many sections of society view making money off money as immoral, historic notions of Usury, the reason why Jewish people have been casted outside society due to their role in money lending. Karl Marx in his critique of Capitalism stated that charging interest was 'exploitation' of the workers (everything he wrote was one big exploitation, his Communist Manifesto is heavy on that concept) with no inherent purpose. Of course Bohm-Bawerk's time preference explained this concept. If I saved then I have produced more than I have consumed during that time period. I may give this to a bank who I charge interest, as they may wish to make use of these savings. The bank in turn may lend it out to a business at a slightly higher rate as they may have immediate plans to hire more people to expand their business in the current time frame however they do not have sufficient capital to do so. They are therefore paying for this privilege. Time preference also applies to entrepreneurs and labor. Labor was not exploited, again as Marx falsely assumed. Labor gets paid upfront for what it does. I go to work and I don't risk my capital, my time - I get paid for what I produce, regardless of what happens in the market. Entrepreneurs don't. They risk their capital, their time and in the end they may not earn a penny. Again time preference explains this, do you want to get paid upfront for less, or potentially earn more later down the line if you succeed.

So how would interest rates fit in with the above example. Interest rates are set based on peoples time preference. If no one saved and lots of people wished to borrow for the current time frame, then interest rates would go up as a shortage of genuine capital would be evident. Similarly if there were lots of savers and few borrowers, interest rates would fall, deterring saving and spurring consumption or investment. The above is just a supply and demand concept, one that Governments always like to abuse.

Once the above is understood the whole economic crisis becomes quite simple to explain. It was the setting of these prices, outside of the markets control, that caused all sorts of industries to exist that were never sustainable in the long term. It's the reason why unemployment is on the rise, why businesses are failing in mass. Many economists are still blinded by such simplicities. BBC's Robert Preston drones on about regulatory structures, but its akin to a doctor putting a plaster on a cancer patient, its the wrong diagnosis. The free market interest rate article sums up this process:

"This illusion creates waste, because it makes people overestimate the available resources. Ventures that would have been unprofitable if interest rates were not artificially low are now embarked upon, drawing scarce resources away from better uses. According to Friedrich von Hayek and other advocates of the Austrian theory of the business cycle, it is this interference with interest rates and the money supply that causes an unsustainable combination of consumption and investment — a boom that inevitably leads to a bust."

We got into this mess because of low interest rates and expansive monetary policy. So how do we try and navigate out of the current situation? By using exactly the same policies as before. Putting another plaster over the other plaster of the cancer patient. A similar re-run of the seventies, more inflation to try and solve the previous inflation. Recession after recession.

This is of course a great magic act that Governments have. Through the inflationary boom, all the 'robust' growth is down to the Governments policies. During the bust it's suddenly the free markets fault, it peoples 'psychology', speculators and so on, but never the government. Blame the banks if you will, but the majority just play this game knowing the rules, profits in the boom, bailouts in the bust (we could also go into the practice of fractional reserve banking - again governments rules, banks just playing the game).

Bubble China

The most recent example of a Government creating an artificial inflationary boom is China as I write. Rather than causing the economy to readjust painfully due to the lack of Western or Japanese demand for their export products, the government have begun on a program of recklessly expanding the money supply, around 30% per annum. This is causing all sorts of incorrect investments may it be the stock market, real estate or certain sectors. The end game? They can't put off their depression merely buy time and make it much worse when it arrives. China's Banks are now copying the Wests - reckless lending fueled by cheap money and their economy will suffer eventually. The Communist party is scared that the depression would be so bad that its people would begin asking for democratic change like I mentioned in my Building Bridges post. We will have to see when.

As bad as the dollar is, where's the alternative? Governments are all bad, its just some are worse than others. There is nothing good I can see around the world right now. We are in a classic bear stock market rally all over the world at the moment. It doesn't matter what the news is, it just goes up. Japans Nikkei after 1990 rallied on numerous occasions, sometimes rallying as high as 70%, but where did it go? Right back down hitting new lows (its real lows we may have to watch, not the nominal price). The sign of a long term great bear market is the size of the rallies, so in my opinion this is truly a great bear market we are in. Lost decade? Only this time global?