I feel I need to return to consider two of the points I raised in my commentary on the Credit Crunch.
However, let me try and give some context to what I am saying.
At the time of Gordon Browns announcement of of his “rescue package”, while he was still in that (“leave it to me, I know what I am doing!”) mode, I expressed my doubts as to the probable effectiveness of his fiscal measures. Historically fiscal stimulus has only been effective where it is clearly targeted to address a specific area of concern. Now, that he has admitted, “he does not know what to do, as there are no historical precedents for guidance”, we can look at things a bit more dispassionately.
The rest of the world have taken their various directions with the main emphasis being on public works or infrastructural development, coupled with targeted fiscal stimulus. In Germany we see a very strong inducement or incentive package to getting older fuel inefficient vehicles off the road and replaced with newer high tech vehicles. In France, we have heard Sarkozy say he will not adopt the British shotgun approach of saddling both the government and the population with an untenable level of debt. The USA “Obama package” appears to have been well considered aimed mainly at infrastructural development coupled with fiscal relief in areas of particular distress, and here we see the intention to put money directly into peoples pockets. He is following the FDR pattern, whether they actually work is a moot point, as there is a large body of economists that believed FDR actually slowed down recovery, however on his side the USA did emerge with a vastly improved infrastructure that assisted future growth.
While Gordon Brown might be right in saying there are no historical precedents, he is wrong if he thinks that plain logic is not the best answer. Most of the rest of the world, appear to be aiming at shoring up their own economies and while this may lead to a degree of protectionism, the fundamental responsibility of any government is, primarily, to it’s own people. We should however be aware that the creation of artificial barriers to international trade is likely to harm ourselves rather than help us. That said, there is no wrong in Government expenditure being targeted on the local economy, even to the extent that it accepts a little premium in cost.
While it is right to recognise that our economy has been based around consumption and debt, it is not right, to simply make consumption the goal of economic policy, there has to be a balance, and more importantly we cannot simply consume and hope the rest of the world will fund that consumption. While, consumption has made the UK economy appear more robust than many others, it has only been possible because of the strength of “The City”. Without that strength …
In my commentary, as events unfolded, I pointed out that there was an extreme danger in placing all the blame for the ills in our economy on the banking sector, the UK has become dependent on “The City”, it was our “cash cow”, unfortunately we started believing that it would generate a never ending flow of money which we could simply consume. Well we have wrecked its reputation so much that it has been referred to as “Reykjavic upon Thames”. Alas, once milk has been spilt, there is little you can do about it, and it will be several years before it recovers from the onslaught of politicians.
I also pointed out that the major part of the lending into the local economy was being funded by foreign deposits, and that we had become dependent on these foreign funds to sustain our way of life. It was not until a couple of weeks ago week ago that Alistair Darling acknowledged that over 40% of lending by our banks was out of deposits in our banks from foreign sources, and that these had not only dried up but were being re-called! All this was obvious from even superficial analysis.
Now as to the allusion that there is no historical precedent for the current circumstances. We in fact have two, which although not exactly the same have sufficient common features … The great depression brought on by the same excesses in the banking world at that time it was trading on margin (a small deposit and a highly geared risk) really no different from trading in derivatives.
The USA under FDR chose, as a solution to the great depression, public works coupled with money creation. To give confidence in its monetary system they separated the activities of Investment Banks from Commercial Banks. In this way people could perceive that money in the Commercial Banks was safe, while those with more risk tolerance could use the Investment Banks where the rewards could be much greater but there could also be losses. If we embark on money creation we must give people a reason for confidence in our money, it is not simply a case of saying we will make a better job of regulation in the future.
During the 1980’s, following the USA in the 1970’s, we tended to bundle all these activities into one, without ever making the population at large aware that the risk profile of Banks had changed. Nor, do we disclose that the bulk of Banks profits are not coming from lending operations but from taking positions, more simply betting. In any game of betting there are always both winners and losers.
The second precedent is specifically applicable to the UK. During the first stage of the oil boom of the early 1970’s, up to 1973, there was a vast flow of OPEC oil money into the UK when this flow started reversing in the second half of the 1970’s the UK was suddenly in a similar position to where it finds itself now. Foreign money on deposit in our banking system is not loyal money and can be withdrawn just as easily as it came in.
That has started happening now and as fast as the Government ploughs money into the banks, we are seeing an outflow from the UK. I fully expect to see a drop in foreign deposits held by the banks greater than the amount the Government has ploughed in. This was the real crisis that the UK faced at the start of the “crunch”. Money flow, from foreign sources, into “The City” was drying up making the Banks less able to maintain their level of lending. We have done a lot to make sure that it slows down to less than a dribble, by slandering the banks.
In the 1970’s Callaghan decided that we could not spend our way out of the trouble and chose to go to the IMF. He was prepared to put pride in his pocket and has possibly never been forgiven.
Gordon Brown has decided that Callaghan was wrong and that he can in fact spend his way out of trouble, this policy will eventually result in a near total collapse of Sterling as the UK becomes dependent on the rest of the World picking up the UK bonds.
At the moment we are seeing a certain amount of inflow, mainly from Europe as they strive to prevent the £/Euro exchange rate collapse from creating a distortion in the trading balance between the Euro zone and the UK.
We have had talk of “quantitative easing”, and, while creating a situation where there is a surplus supply of money in the money markets fighting for a home, may ease the ability of companies to raise loans its ultimate result will be inflation.
Before continuing there are a few quotations that are pertinant.
From an analysis of the German Hyper Inflation published by Scientific Market Analysis in 1970:
“If history teaches anything, it is that government cannot be trusted to manage money. When currency is not redeemable in gold, its value depends entirely on the judgement and the conscience of the politicians.”
“Especially in an economic crisis or a war, the pressure to inflate becomes overwhelming. Any alternative may seem politically disastrous. Whether it be the Roman emperors repeatedly debasing their coinage, the French revolutionary government printing a flood of assignats, John Law flooding France with debased money, or the Continental Congress issuing money until it was literally “not worth a Continental,” the story is similar. A government in financial straits finds its easiest recourse is to issue more and more money until the money loses its value. The entire process is accompanied by a barrage of explanations, propaganda and new regulations which hide the true situation from the eyes of most people until they have lost all their savings.”
or perhaps this quote from Hans E Sennhotz in his “Age of Inflation” might sound a little familiar.
“When all other explanations are exhausted, modern governments usually fall back on the speculator, who is held responsible for all economic and social evils. What the witch was to medieval man, what the capitalist is to socialists and communists, the speculator is to most politicians and statesmen: the embodiment of evil.
The same German officials who denied the very existence of inflation lamented the depreciation caused by speculators, or they blamed the Allied reparation burdens and simultaneously denounced speculators for the depreciation.”
In all the rhetoric that has flowed during recent months we see the same tenor, the accusing of “The Banks”, the hedge funds and of course the speculators. In fact they sound like that song that was in vogue when I was still in Junior school “Somebody must be to blame”.
It is never a case of “Oooh I made a mistake I never foresaw that when I took away the regulation of the Banks from the Bank of England and handed it to a Quango there would no longer be any regulation of their activities, only regulation of the charges, procedures and relationships with the consumer or public.”
“I never realised that the Bank of England was doing anything important when forced banks to increase their reserves or slow down the creation of money”
“I didnt realise that taking things off Balance Sheet still amounted to borrowing, or creating money as the funding would be sold off overseas in the money markets”.
Yes, perhaps there are few precedents that show a clear route out of the mess you have landed us in, however economics is not a case of looking up the Civil Servants manual and seeing that when “x” happens you do “y”.
“Economics … is a science of recognizing secondary consequences. It is also a science of seeing general consequences. It is the science of tracing the effects of some proposed or existing policy not only on some special interest in the short run, but on the general interest in the long run. In seeing that economics is a science of tracing consequences, we must have become aware that, like logic and mathematics, it is a science of recognizing inevitable implications.” (Ludwik von Mises)
There are however a lot of precedents that should have enabled you to see the consequences of unbridled money creation. We have not yet reached the worst of those consequences … inflation and then Hyper-Inflation. Yes throughout your tenure there has been Inflation well above the CPI figures you so dearly cling to. The USA is currently running inflation at 8% (if we take away all the changes they instituted to their statistics to make things look better than they are). You are not to blame for most of those changes in the UK, as they largely preceeded you, but you have been good at playing the statistics game … increasing public sector employment by nearly 1 million so that the unemployment figures are not so bad … making a lot of this under employment, say 20 to 30 hours a week, so two people appear to be employed instead of just one. And naturally this also has the effect of increasing GDP without actually increasing the outputs of the country, so that it helps make your statistics look good.
The UK is currently set on a course where inflation will get out of control and the value of Sterling will plummet! The USA appears to be choosing a similar course although a bit better thought out but similar potential results.
In my original article I postulated that the housing price bubble needed to be pricked. This is a frightening course of action, but until taken we have no hope of getting back on an even keel. One cannot rebuild an economy where part of the foundation is pie in the sky, and Germany taught us that you cant just issue money (quantitative easing), as the consequences are even more dire than the situation we are in now. Remember, economics is the science of recognising consequences and we need to be clear about the probable consequences of any action we take. The nationalising of Northern Rock put us in no better position than a liquidation would have and possibly far worse. After ploughing in £20 billion to RBS we find that its net equity is only £1 billion when we exclude the £25 billion of goodwill hiding in its Balance Sheet (taking into account their hidden losses which were announced recently). We listen to the HBOS/Lloyds saga as it continues to unfold and start wondering how much more is going to be needed.
If we prick the property price bubble what are the likely consequences? Popular banking wisdom is that the property market wont start recovering until it has dropped about 50% from its peak in 2007.
What would this mean?
Using Nationwide figures the housing prices peaked at an average of £184000 in 2007, which means an average of £92000. My own calculations based on a start point in 1997 of £62000 allowing acceptable inflation would give a figure of £77000, so popular banking wisdom is probably quite close to the mark. My own table suggests that all mortgages taken out since the end of 2001, if the deposit was 25% or less, would be in a negative equity situation if the bubble were pricked. No government would survive the storm.
The safety net I constructed was that the government (or more accurately, The Bank of England) settle the proportion of the original mortgage bond equal to the fall in prices of houses and take a second charge mortgage ranking first in preference after the original mortgage and only repayable out of the proceeds of future sales of the property, until eventually redeemed.
My model suggests this amount would be somewhere between £250 billion and £400 billion, based on an average of 1 million homes changing hands each year.
If we take the lower number, based on the banking industries perception of where true value returns to the market, and assume that the market needs some £150 billion to get out of its current straits, the banks could be forced to use the remaining £100 billion to take up Government bonds, improving their reserve and solvency ratios. Part of the £150 billion would naturally also return to the Government as the Banks would buy back the shares bought by the Government, thus unwinding the Nationalisations.
This amounts to printing money on a far larger scale than I think they are currently contemplating.
Why do I think this can work when I say quantitative easing is more likely to bring about inflation?
The basic difference would be that The Bank of England is issuing the money against a “tangible asset” a proportion of the future surpluses arising from sales of properties. Instead of talking about confidence in Gordon Brown, as the Labour Party are wont to do, we are talking about giving a reason for confidence in our currency!
Our Gold reserves having been sold at the bottom of the market, and there is virtually nothing backing Sterling, so let us say we are putting part of our property behind the currency.
What makes me think that second mortgages on property in negative equity can add value to Sterling?
History, dear man, history!
The German Hyper-Inflation of 1922/1923 was stopped dead in its tracks by the issuing of a new currency, backed by what? Backed by land! No one ever believed that they could redeem their marks for a piece of land, but everyone recognised a serious intent to stop printing money … land owned by the German Government was finite there could be no more quantitive easing, it was a one time action … and it worked.
If we choose quantitive easing we have to remember that it is a one time solution, not a road that can be re-visited again and again as the German Government in the period 1919/1923 did. It took 4 years for the full consequences of those actions to become apparent.
Back to my basic theme, an economy must work for all its people, and it is the Governments responsibility to bring about that environment, so lets get the interest rate up to 6.5%, so that we do create an environment where people can save for a retirement and those living on the interest from their past savings can also live.
My proposals would result in a total easing of the money supply situation within the country. The Banks would be more liquid and their solvency ratios substantially improved. We could now separate Commercial Banking from wholesale or Investment Banking and give them different licenses with different regulatory systems. There is a need for people to understand the different risks involved in the two sectors, the regulation of the Commercial Banks should be in the hands of the Bank of England who should in turn provide fairly solid guarantees for Deposits held by the Banks. The Investment Banks could be regulated by the FSA with less stringent controls, however the people would be aware that while the returns might be greater there are risks attached.
To the people who are affected by negative equity and to a greater or lesser degree that involves properties bought after 2001, they would have the option to convert Mortgage Bonds where the Bank of England takes up a preferent second charge over their property, redeemable out of the proceeds of future sales of the property. Assuming that we also raise interest rates to 6.5% this would mean that someone who bought a property at the peak of the market in 2007 on a tracker mortgage of £140000 would have his instalments reduced by £1000 per year. Those with fixed rate mortgages even more. Obviously the benefits would vary depending on when the property was purchased. A conservative estimate would be that this measure would put some £2billion a year directly in the hands of consumers available for savings and or consumption.
What we would now have, is an economy that makes conservative saving for retirement a possibility as there would be a natural interest rate. It might make business decisions a little more conservative as the cost of borrowing would be higher. The pound would once again start assuming a real value and become attractive to foreigners as a medium to hold.
Based on property values increasing at a rate of inflation of 2% the extra money created would be redeemed by the Bank of England over a 10/20 year period, this redemption could either be used to reduce taxation or retired from the monetary system, depending on the needs of the economy at the time.
What we also need to understand is that an economy cannot mainly be based on service industry and government expenditure. While, government expenditure can boost GNP figures, it is no substitute for the productive economy.
The current crises has removed our eyes from the fact that although we are currently oil neutral (imports roughly equal to exports) this is not a continuing situation. Over the next 10 years we have to increase the production of goods to export and pay for an increasing oil import bill as well as reduce our dependence on oil.
This implies changing the type of cars we use as well as changing the nature of our electricity generation. It was interesting to note that part of Germany’s fiscal stimulus was an inducement to consumers to retire fuel inefficient vehicles. Also Obama seems to be suggesting the need for USA to move to electric cars. These measures in fact have a negative impact on the environment unless we switch away from the use of fossil fuels for electricity generation, as storage of electricity in batteries is not 100% efficient.
Gordon Brown has continually emphasised the need to switch to the high tech industries, or new industries that come from the information age. Alas, we need to look at our infrastructure, we are playing with broadband technology that will soon be third world in its standard. Paris will shortly complete its conversion from copperwire to fibre optic making 100Mbs the norm, we talk of achieving 2Mbs by 2012!!
An infrastructure development that could both provide employment and stimulation, would be to set in motion a 5 year project to cover the whole UK with a fibreoptic network right into peoples homes … then we might see the explosion of opportunity that the information age offers.
Our priorities over the next 10 years are therefore.
1. Switch away from fossil fuel electricity production to nuclear and re-newables.
2. Make our infrastructure for information technology the best in the world.
Both of these, as projects, are mind boggling in their scope and potential .
I will continue with the second point, the world monetary system, in the next edition.