Where to now?
Oh! It was the American sub-prime market that caused the collapse of Northern Rock and the start of the Credit Crunch, or so we were told.
Oh how gullible we be … its all a matter of confidence, they say. Confidence in what I ask?
Let us look at the so called sub prime-market.
In probability there were no more than 10 million mortgages granted in this market. A very small proportion of total mortgages in the USA … if these all went sour could it crash the whole financial system?? For a minute let us assume the average mortgage in this sector of the market was $150k this would mean that the total exposure of the financial system in this area was of the order $1.5 trillion dollars sounds alarming, but let’s bring it into proportion. Could all of that be bad? No there should at least have been some equity in the mortgages lets say 50% … that brings the number down to $750 billion still alarming you might say!! The USA government have already under propped the financial markets with close to that number … in the UK we have put in nearly $200 billion. Still the contagion is with us … so what is the real issue?
At issue is the way our monetary system has been run for the last 37 years. Nixon effectively suspended the Bretton Woods agreement in 1971 and we entered the era of free floating currencies. The obligation of countries to maintain their economies in such a way that their currency had a fixed relationship with gold was gone.
The free floating currencies suited politicians … as devaluation of their currency could be blamed on market forces instead of their failure to manage their own economy. The initial effect of the Nixon action was to make the Dollar the benchmark of all currency valuations. This naturally resulted in Central Banks around the world holding bigger and bigger Dollar reserves … effectively meaning that the USA no longer needed to produce as much as it consumed … it could simply print paper to make up for the deficit.
The initial result for the world was the rampant inflation of the 1970's, resulting in massive flows of money around the world as people sought safe havens for their savings. The UK was one of the early beneficiaries of these flows as Arab oil money sought to limit its exposure to the Dollar. Sterling became the second major Reserve currency of the world, and the UK economy was able to relax and enjoy the results of these flows. By the end of the 1970's Oil money started fearing its exposure to the IOU's of the USA and UK and fled into gold. This resulted in James Callaghan having to go, “cap in hand” to the IMF to borrow money to repay the Arabs. Margaret Thatcher then embarked on an extreme monetarist economic policy that was easily understood be the ordinary person … albeit with pain, “you can only spend what you earn … once that pot is empty you need to tighten your belt”. This brought the first big modern time crash in UK housing prices … there was no longer that big pot of Arab money to fund mortgages.
North Sea Oil came to the rescue as a large slice of the UK imports were eliminated reducing the need for increased outputs and a period of prosperity dawned by the mid 1980's. Thatcher's government recognising the changes that were coming to the world monetary system deregulated the financial markets in 1987 (the big bang) to enable them to compete better for the large flows of International money that would occur as globalisation became a reality. “The City” assumed a cornerstone role in the economy.
Going hand in hand with garnering the cash flows of the world comes an obligation to find productive ways to invest those cash flows … after all you need to be offering people a return. The means was to change the pattern of home ownership in the UK … as people were encouraged to buy their council houses. Also of course the scale of privatisation meant that a large portion of these funds were invested in previously state owned assets … we were transferring part of the ownership of the countries assets to overseas. All this created a new boom in housing prices that were doomed to crash once again only a few years later.
The transference of state assets to foreign ownership actually meant that we were getting foreigners to pay part of our tax bill … as the revenues from privatisation were used to reduce taxes. This was not sustainable in the long run and the UK was forced to break from the discipline implied by maintaining its currency within the 5% band allowed by the ERM snake. This precipitated a drying up of the money flows and a crash in the property market in the early 90's.
What I have been trying to illustrate is that we are not going through anything new, but simply a consequence of Political decisions. They are all the result of excessive money creation! In this case not the government printing money in the conventional sense, but by following economic policies aimed at mopping up the worlds liquidity on the promise that we can invest that money on your behalf and generate good returns.
This has in turn created capital and money markets awash with cash, which will automatically become more and more creative as the bright men in “The City” try to find ways of putting that money to good use.
Continue to part 2 ?