Nov 30 2009
The financial elephant in the room
One by one the excessive borrowing bubbles are punctured. Now everyone knows the banks overdid the borrowing and lending in the US and the UK. All are wise in retrospect over sub prime mortgages. Most now see that Ireland and the Baltic states overdid the borrowing. Now all recognise that Dubai built its property on too much borrowed money.
So the question is, why isn’t everyone equally wise over the UK government borrowing too much? How many more warnings will it take? Why do some commentators still seem to think the way to solve a crisis brought on by the private sector indulging in too much credit can be resolved by the public sector borrowing too much?
The temporary answer is printing money. The Bank’s creation of money has allowed them to keep interest rates on government borrowing low, and helped them raise the huge sums the government needs to borrow this year. More should be asking, what will happen to interest rates and to the sums the government still needs to borrow when the printing stops, as it will have to do sometime next year?
It is true they have built into the regulatory framework of the banks the continued need for them to buy more government bonds – to lend more to the government on reasonable terms. This will mean continued distortions, with the government enjoying more favoured access to credit than the hard pressed private sector.
The irony of their money go round is acute. Because the credit is pre-empted by the government the private sector remains operating at low levels of activity. This then leads the government to say it needs to spend even more to provide additional stimulus, so requiring the government to borrow even more. This in turn pre-empts more credit and perpetuates the two tier interest rate and credit structure. Far from encouraging a smooth and sustainable recovery, this is storing up trouble for the future. It has also slowed down the recovery. The Uk is going to be about the last out of the recession.
The government deficit is the elephant in the room.One day it will become clear that it is not affordable, that it is impeding private sector recovery. Then most will come to realise what should be obvious in advance.
31 Responses to “The financial elephant in the room”
John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College...
As you say, the Government has “built into the regulatory framework of the banks the continued need for them to buy more government bonds.”
This money lent to the Government on very low yields now forms part of the asset base of UK banks: in theory the lowest-risk part of their portfolio. If government debt yields rise when quantitative easing ends, then those UK banks will see the value of their asset base declining. Far from being the safest part of their asset portfolios, they will be as risky as any other.
To the extent that this crisis has been one of collateral as well as liquidity, the potential for this crisis to bubble over again is quite terrifying. If it does spread to sovereign debt, governments will not be able to do anything about it.
There are lots of wise people (and quite a few of us who would not even claim intelligence) who know that this Government borrowing is making things worse. It’s been obvious for years.
It has the effect of prolonging the recession, probably causing a second dip when the printing presses eventually stop.
Unfortunately, Mr Brown is playing his last political game particularly badly. The direct effect of this is clear to see in the countries economy – rising unemployment, rising taxes, ever wilder social engineering. Even the economic immigrants are beginning to return home, in spite of the free money that Mr Brown gives to those who have never contributed.
It is hardly conceivable that the Labour party will return victorious at the impending election, so they really don’t care how badly they scorch the earth.
For the most part, I agree. The extension of excess credit unbacked by real savings is the root of our present problems. Consider the following from 1936:
“The monetary explanation of the trade cycle is not entirely new. The English “Currency School” has already tried to explain the boom by the extension of credit resulting from the issue of bank notes without metallic backing. Nevertheless, this school did not see that bank accounts which could be drawn upon at any time by means of checks, that is to say, current accounts, play exactly the same role in the extension of credit as bank notes. Consequently the expansion of credit can result not only from the excessive issue of bank notes but also from the opening of excessive current accounts. It is because it misunderstood this truth that the Currency School believed that it would suffice, in order to prevent the recurrence of economic crises, to enact legislation restricting the issue of bank notes without metallic backing, while leaving the expansion of credit by means of current accounts unregulated. Peel’s Bank Act of 1844, and similar laws in other countries, did not accomplish their intended effect. From this it was wrongly concluded that the English School’s attempt to explain the trade cycle in monetary terms had been refuted by the facts.”
And, perhaps bearing in mind the effect of China’s recent emergence as a pool of inexpensive labour:
“In issuing fiduciary media, by which I mean bank notes without gold backing or current accounts which are not entirely backed by gold reserves, the banks are in a position to expand credit considerably. The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as “suppliers” of additional credit, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention. The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought “profitable” if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found “profitable” and can be initiated. The more active state of business leads to increased demand for production materials and for labor. The prices of the means of production and the wages of labor rise, and the increase in wages leads, in turn, to an increase in prices of consumption goods. If the banks were to refrain from any further extension of credit and limited themselves to what they had already done, the boom would rapidly halt. But the banks do not deflect from their course of action; they continue to expand credit on a larger and larger scale, and prices and wages correspondingly continue to rise.”
Via http://mises.org/tradcycl/austcycl.asp
Unfortunately, QE will not solve our problems. Pushing new money through central bank actions in compensation for the diminishing supply of credit from the rest of the banking system can only serve to further distort the capital structure of production away from that which would be sustainable in the absence of new money. From Hayek’s 1974 Nobel lecture:
“The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity.”
In other words, you are quite right: we had better start doing something substantially different, quick.
I agree, and I feel that we are in for some very difficult times. With Welfare now costing all of our Income tax income, and the national debt worse than at anytime since the end of ww2 in very real terms. A fresh Conservative government will be in a mess not of its own making. Conservatives hate raising taxes, but frankly what other choices will there be? Welfare reform will take a number of years, and that is assuming we can get at least some of our JSA recipients back into work. Interest rates are currently very low, but as John correctly indicates this is at the price of QA, a very dishonest printing of money. Our gold has been swapped for Euro’s a soft fiat currency for a hard one, what was Brown thinking? We are borrowing at a rate that is simply unsustainable. Yes pay restraint in the public sector would help a little, but a further pay restraint in the private sector? Interest rates are of course set to rise, this is utterly certain in fact, and most likely by early next year IMHO. I am of course completely barking (or so I am told) because I do not support an In/Out referendum, but only a complete fool would destabilise our relationship with the E.U. at such a dangerous time. If we get this wrong, by as an example taking to much notice of Phillip Blond, who ideas are clever, but are not for right now I feel, then we will be sunk. We need a period of tight control of money supply, how long? Maybe a full decade, maybe far longer. Of course getting John Redwood back into the Government would help a great deal, as he is one of the very few Conservative Intellectuals, that is willing to tell it like it really is. A hung parliament would of course make matters far worse, as the silly Lib-Dems are almost as foolish as the Labour party. Even though I know I am likely to end up worse in real terms I feel that not only the public sector but even those of us who are soft-funded via the welfare spend, will have to tighten our belts still further. My disabled wife still recalls with some bitterness a 1p rise in UB at the start of the 80’s recession. Frankly I thought Maggie was right then and I urge the coming Conservative government to do the same. JSA is already of course a very low benefit in real terms, as Labour attempted to starve the long term Unemployed back to work. Of course we also have to avoid if possible deflation, which would be just as bad for us as inflation. With so much QA money already in the system there may be a temptation to print some more DON’T!! is my strong plea, please we must get real. Brown claimed to have illuminated Boom and Bust, but he may well have only succeeded in ending Boom, condemning us to a very long period of bust at the very best. Keeping our credit rating is of course vital, as we will be borrowing for a few more years yet. 8 years is far to long a time to get things under control, I would hope we could do it in five, but if that possible? What do you think John, I am frankly pessimistic.
QE not QA !! Its early and my dyslexia is always worse fearly and late in the day.
Your argument cannot be seriously challenged. If you also provide the answer to the inevitable question of how the private sector can lead us out of recession when public spending is cut, you could claim “check mate!” If only your colleagues on the Conservative frontbench were so clear thinking and articulate as you are!
In which case we now have two elephants in the room. The government deficit and the constraints put upon this country, in its economic ‘latitude’, by the EU
I read an excellent article about this in the Spectator. There seem to be two problems.
The first is, as you say, loads of government borrowing with little hope of any kind of restraint. The words flow too easily: “Keynes”, “warding off the recession” and so on. Meanwhile we all know that billions, yes, billions of pounds are being simply thrown away by the wasteful and bossy government.
The second is not mentioned in this article – but it is something which you often write about. What has happened to the “toxic debts”? Why aren’t the banks being forced to cough up all the details of their balances? A team of accountants could be sent in immediately.
Money is, at the end of the day, trust. How much do we trust the government? How much do we trust the banks? Do I feel safe with them?
In Iceland, they immediately owned up. The economy is, apparently, no longer a basket case.
In Japan they fudged and got a decade of stagnation.
You should also read Frank Field’s excellent blog. Is anyone going to listen and take action?
http://www.frankfield.com/blog/q/date/2009/11/26/the-four-of-horsemen-of-the-apocalypse/
alan jutson Reply:
December 1st, 2009 at 2:51 pm
Brian
Thanks for the link, had not visited Frank Fields site for some while.
As usual he seems far and away one of the most sensible and Grounded Members of the Government Party, not afraid to air many views of his own.
He is rather unique, as he does not simply follow the usual Government spin and properganda for Party political sake. Oh how I wish there were more Members like him on both sides, who would stand up and speak their minds.
What a shame his views and ideas seem never to be taken into account by his own Party, and will stand little chance of being recognised should the Government change.
Brian Tomkinson Reply:
December 1st, 2009 at 7:39 pm
Alan,
I agree with you. There are some good MPs, but sadly most of them are sidelined by their parties. John Redwood and Frank Field being perhaps the best examples.
If the banks are being forced to buy government bonds, what happens if the government defaults, as in Dubai? Presumably the banks go broke for a second time!
Personally I would rather my bank invested my savings in the private sector; if I wanted to invest in government securities (which I don’t) I could buy National Savings or Government stock and probably get a better rate of interest.
Even so, as a mere engineer, I can’t see the point of the government lending the banks money, getting shares in exchange, and then forcing the banks to use the money to buy government stock, presumably so the government now has more money to lend to the banks!
No wonder gold prices have reached an all time high, at least the investors have something tangible for their money!
Stuart Fairney Reply:
November 30th, 2009 at 2:03 pm
You will note of course that struggling as Dubai now is, they aren’t just printing oney out of thin air to pay the debt as a Sovereign country could do.
For my part, I think Dubai will be back with a vengance when global inflation takes hold and the debt is eroded because the fundamentals (ie no taxes)are still sound.
I always thought that the rules about elephants in the sitting room were to ignore them but that’s the very last thing we need to be doing with this elephant!
The countries you mentioned as having been noticed are all small ones. The big ones have currencies which the rest of the world is more nervous about refusing. The biggest of all is not Britain but the USA. While it may take longer to fall from a high place the result is more spectacular. The Gulf states have certainly been considering a repricing of oil not in dollars but in a currency basket.
Mark Reply:
November 30th, 2009 at 1:17 pm
The currency used for pricing oil is largely irrelevant: you could use forints a firkin if you wanted to, and your computer screen would convert to the currency of your choice. The currency used for payment is perhaps a little more relevant, as payment is usually in “federal funds” – i.e. conducted via New York. Even so, there is little to stop a payee from converting dollars to a currency they prefer to hold, using the forward market where appropriate.
I do not think that the government is actually borrowing at low interest rates at all. They have created a false market in gilts through a combination of statutory requirements e.g. for pension fund holdings, and QE. QE acts like a shelf issue: the gilts are not effectively sold to a third party. It’s a bit like a developer “selling” a few flats in his development to a subsidiary of his company so that he can claim that they are “worth” £1m apiece, when real buyers will only pay £250k: he may even buy back some properties sold off plan at a “discount” to an investor at the inflated price. Few are taken in by such a false prospectus now that bubbles have burst.
Only when gilts are sold to genuine third parties (i.e. when QE has stopped being the budget deficit financing mechanism) will we see what the true rate of interest is for government borrowing. Long dated low coupon issues in particular could bring in much less “real” money than their current artificial sticker prices.
The effect could be exacerbated for non indexed linked gilts if higher inflation gets reckoned into redemption yields, though in real terms it would be little different to the real liability of the index linked bonds.
Mark Parker Reply:
November 30th, 2009 at 3:58 pm
Good points, and also bear in mind that the govt needs to “churn” about 5% of the national debt every year because gilts mature and have to be redeemed and new ones sold. So even the fixed coupon borrowings aren’t really fixed, just slow to react.
Mark Reply:
December 1st, 2009 at 7:13 pm
I covered that aspect in a previous post here, detailing figures for redemptions over the next several years from data from the DMO:
http://www.johnredwoodsdiary.com/2009/11/12/the-bank-forecasts-inflation-to-rise-sharply/#comment-49012
That post also highlighted the alarming situation in the mortgage market, which has been financed extensively by borrowing abroad. In turn, the borrowed money has been spent to a significant degree on financing the trade deficit – i.e. paying for imported goods: remortgage and buy a BMW X5 with the proceeds of gearing up to this year’s house prices.
Nationwide now tell us they see house prices up by 10% over just the past 10 months: a radical inflation that is ignored by the BoE’s CPI indicator (and isn’t reflected in the RPI either). Indeed, I have just noted a house that completed sale on 20 Jan 2009 for £950,000 (after several months of being on the market with the asking price reducing from £1.2m to £995,000). It is now offered for £1,375,000 by the new owners, who have done nothing to improve it whatever (indeed, the new brochure is less appealing than the old one was, showing scant and cheap furniture). Chutzpah by the owner and agents – certainly. A 44% increase in 10 months is hyperinflation territory.
My thinking is that interest rates have to go up in the real market, and by a larger amount than most people anticipate. Add to that is that for essential goods and services for all those in the lower sectors of income, inflation is already present and rising sharply. This does not emerge in the general indexes because they are based on characteristics of demand and consumption amongst the higher income groups.
I agree with those who belive that intrest rates will rise, it is a simple matter of mathmatics. Indeed holding these rates down by further QE would only put this off for a short while. As always John is right (as is his moderation, and editorship of this site)as he so often is. Indeed I have often argued that the US is as an economy is in a mess as well. Indeed many of our systemic problems are very old indeed, and have not been tackled dispite exsisting for longer than a century. We are essentialy still suffering from an economic cycle, that results in a boom quickly follwed by a very hard bust indeed.
“This in turn pre-empts more credit and perpetuates the two tier interest rate and credit structure. Far from encouraging a smooth and sustainable recovery, this is storing up trouble for the future. It has also slowed down the recovery. The Uk is going to be about the last out of the recession.”
The last major economy,out of recession (I would inject) but I agree that this is sadly true. Our Economy being so dependant on the Finacial service industry.
Mr Redwood: leaving aside the issue of AGW itself, it has been suggested by some, and just today “Friends” of the Earth, that carbon trading is the next sub-prime-like financial bubble being primed to burst at some point in the future.
It seems to me an extraordinarily dangerous thing to do to trade nothing – on a par with the Catholic Church setting up a futures business trading in Plenary Indulgences. (Of course they used to do something similar a while back.)
What are your views on this? (Maybe you have covered this topic before.)
Not only is QE funded Govt spending distorting the current economy it is going to massively change investors behaviour going forward. All investors now know that the Govt will not let asset prices fall so its a one way bet, you cannot lose. Savers will know that the Govt will devalue their savings by printing money so they had better store it in Euros or Swiss Francs.
Obviously these 2 scenarios cannot coexist and have low interest rates. The economy has to give way somewhere and that is the exchange rate and inflation.
This is just the beginning.
I seem to recall that back in the year 2000, a long time ago now, the media were saying that privately Labour politicians are very worried about the ballooning house prices (the main ingredient of the credit bubble in this country.)
Memories are very short and these days the media takes the the view no-one could have predicted the credit crunch, but really, the elephant has been standing in plain view the whole time.
Does anyone remember David Clementi, Deputy Gov of the BoE, back in 2002 he said to the Treasury Select Committee: “I said in April that the level of house price inflation, then running in the mid-teens was unsustainable. Since then we’ve seen something of an acceleration … and the longer it goes on, the sharper is likely to be the eventual adjustment.” (Quote from Wikipedia.)
So they were told, they knew 10 years ago it would end in tears, but that didn’t stop them from inflating the credit bubble, ultimately just to buy votes.
Just we like we all know a sterling crisis will occur unless a grip is gotten pretty soon.
Our media is only too willing to peddle the government’s line and the few good investigative journalists we have don’t seem to have the funding to produce good material for public consumption.
Videos (can ed)… paint a graphic picture that even economic ignoramuses would find alarming.
Might not the Tories produce something similar, with the help of the TPA?
It scares me to think you’ll be back in Government soon. Whatever Labour has done wrong, I’m sure it would have been 100 times worse under your nasty party.
‘The government deficit is the elephant in the room.One day it will become clear that it is not affordable, that it is impeding private sector recovery.’
I think you are being too logical, John. Most people couldn’t care less about the government deficit, including the Labour back benches. As long as their every day lives seem to be carrying on as normal, they don’t care and don’t want to know. Of course, this is exactly what Gordon Brown is counting on to win the general election. Unfortunately, a lot of people have no idea where ‘government’ money comes from. In America, a poll carried out by CNBC a year ago found that 20% of people thought that the government had its own money and that was what they were spending! Of course, with the introduction of QE, it turns out that the government actually can create its own money. (How stupid was I!) We just have to hope that the majority of people who bother to vote decide that they prefer the look of David Cameron to the look of Gordon Brown. Bizarre as it may seem, the future of Britain may come down to just that!
I agree that the government are using the scarce funds available by banks to finance their own debts and crowding out the private sector.
The recovery will only come when the private sector is able to become profitable again. With government stimulus there is no circulation of money only inflation.
It in part explains the price of gold. Both the US and UK governments are printing money. I don’t think gold is in a bubble yet – because until the printing stops, and deficits brought in, Gold will continue to rise.
I can’t imagine who would want to owe money to the UK government for 20 or 30 years, unless they’re forced to. A hung parliament would be create carnage. In such as circumstance, the best that could happen is that the Tories do not form a minority government, but let Labour: it would be finished within a year, with the UK bailed out by the IMF and our currency devalued (even more than it has already).
What we should do is print money and inflate the banks balance sheets and make it liable for a 3% interest charge unless lending increases.The Banks should have to be 100% transparent with the IMF doing the audit.In return for all that printed money the Banks would have to give all their toxic assets to the state.By taking out toxic assets,boosting the banks balance sheets and restoring confidence by going for 100% honesty over the state that things are in you could get a recovery going.That would end the Credit Crunch.
The Bank of England should be in charge of banking regulation as they have hundreds of years of experience and by getting rid of the FSA you would streamline things thus enabling a more efficient response to future events.The inflation target should be 2% on RPI-x so that you lock in the benefits of low price rises while boosting confidence as the inflation measure is more credible.
MPC members should have seven year fixed terms that cannot be renewed so that the promise of reappointment can not be used to induce lower interest rates at election time.That would be good for economic stability as you would have the same crowd in for a fixed period and political meddling would be less.
Banks should have to inflate their balance sheets in a boom to fund lending in a recession so that credit is not excessive in the good times while there is enough lending to cushion the economy in a recession.Should deflation threaten the MPC should authorise the printing of money to buy assets while bank lending should face curbs if asset bubbles threaten to get out of hand.
So it is possible to mend our broken financial system and to ensure greater economic stability in future.
John Redwood has been right with his views on cutting public spending & borrowing.We do not want investors buying bonds to fund a growing public debt as that just imposes great burdens on future generations.Rather we want investors putting funds into business expansion so that productivity,jobs and prosperity are possible in future years.
John Redwood is right on target. The deficit is there because public expenditure is 48% of GDP and taxation etc. is 38% of GDP. We should aim to get both to 40% by the end of the next parliament. Public expenditure reduction will bear most of the brunt.
There has been a substantial rise in public expenditure in real terms since our last year of office, FYR 1996/7. Of that increase, 70% has been in health, eduction and social protection. I don’t feel that we have had 70% of extra value in those sectors, so they should not be protected from the cuts; there must be no sacred cows. And reductions in the amount spent on the retired elderly must play their part.
However, most domestic expenditure cuts will cause some pain, so let me suggest a few cuts is our foreign expenditures.
Get rid of all government to government foriegn aid, and also reduce contributions to IFIs. It is a major source of corruption. For example, in Kenya in the days of Daniel Arop Moi, no money for the maintance of Nairobi’s city roads got through, because it was channelled via the Ministry of Local Government to the city Municipality, and the Ministry of Local Government contained many people with sticky fingers. Poor countries want trade not aid. Far more good would be done by scrapping Europe’s agricultural protectionism, America’s protection of its cotton industry etc. If you want to help Africa, there are several private charities that promote low tech products that can be manufactured locally e.g. a refrigerator made of two earthenware pots with a layer of moist sand in between.
The EU is demanding that we give up our seat on the IMF board, to be replaced by a European representative. Go for it, and also stop giving any contributions to that unnecessary institution. The IMF was originally formed to provide loans to protect fixed currency exchange rates under the old Bretton Woods agreement. But fixed exchange rates are an anachronism and should go, ergo the International Mischief Fund should go too.
Don’t contribute anything to the new EU posts set up under the Lisbon ‘Treaty’. In particular, do not finance President Rumpy Pumpy and Baroness What’s-her-name and their accommodation and support staff costs. In conjunction, every time either of them makes a pronouncement on European policy, ring up Obama and Clinton and tell them there is no such thing as European policy.