Printing More Money

Printing more money is well understood to increase inflation, but also to diminish the value of debt. Clearly, the latter consequence is prioritised over the former by the current government. One may conclude that this is a tactic designed to ameliorate immediate problems at the expense of later problems. Do they have a new idea, or are they just manipulating problems to improve the outcome of an imminent election. They may be timing the shift between problems, so that an election can be held as we seem to be leaving the old problem behind, but before the new problems are pressing. The fact that the current problems even exist gives one no confidence that they have more than rudimentary skills, as demonstrated by this crude inflationary tactic. Certainly, they seem to lack the imagination to find a new solution that one might hope such highly privileged people would have.

Icarus Economy

I distinctly remember Gordon Brown not so long ago implying he should receive plaudits for a successful UK economy. I also remember thinking that he did not do all the work, we did, the best one can say for him is that he did not get in the way too much.

Now it seems the economy is going pear shaped, will he be as quick to seek the responsibility for that? Perhaps there are problems even his mighty skills could not quell. Then again, perhaps it was just a combination of good fortune and our application that allowed the UK to prosper.

If we flew too high fuelled on hubris, we would do well to remember who was the designer of our wings.

Understanding the Credit Crunch

This post documents my understanding of the credit crunch and its associated ructions thus far, along with some wider understanding of related important economic factors. In it I address: what are the problems, what caused the problems, what are the consequences of the problems, what is being done to fix the problems and what are the consequences of this fix.

What are the problems

The problems are manifold and the pressing problems for individuals such as elusive credit, falling house prices and job insecurity are really consequences of problems in a larger picture, so I will focus on that. That larger picture has two important players, the large financial institutions and state / central banks controlled by government(s), together they modulate economies. The main macro scale problem for the money lenders seems to be a lack of confidence in their ability to avoid collapse under the weight of bad debt. Specifically, it is the fear that much more than expected of what has been lent will not be fully recovered and lead to large enough losses to make the lender unable to continue in business. The main macro scale problem for state / central banks seems to be the possible collapse of money lenders, especially those that also provide savings services. The collapse of large financial institutions will have a negative effect upon the confidence of the whole financial system that could cause a cascade of secondary problems through an economy.
Certainly there is a poor position on mortgage debt and one does have to wonder how it was not obvious to the lenders that they were getting into it, but that does not mandate rampant defaulting on repayments. It was obvious to me for years that a property bubble was forming and would need correcting. I always assumed it was even more obvious to lenders and that they had calculated the best level of risk to accept in order to maximise profits, balancing those that would continue to pay with defaulters. It is rather a surprise and suspicious that they claim not to have seen it coming. Regardless, the lack of lender confidence slows down business as usual and perversely increases the probability that lenders will fail. It is the cessation of business as usual at the money lenders that is creating the dramatic economic effects. Unless we can identify the causes and find fixes for the problems the fear of failure will translate into actual failure and the problems will be amplified.
The credit crunch problems are exasperated by shortages of food and fuel causing steep price increases. These are a simple consequence of supply not keeping up with demand. Although their timing is unfortunate they are only related in so much as they restrict consumer spending patterns, which has a deleterious effect on business, slowing overall growth and confidence.

What caused the problems

Housing has increasingly been used for profiteering. It always has been used this way by architects, builders, mortgage providers, landlords, estate agents, solicitors and surveyors, among others. However, recently two classes of interested party have burgeoned. One class is the speculators. Speculators have no product and offer no service, they are simply there to profit and are the biggest cause of the problems. Speculators pump up what they have already identified as hyperinflation in prices. Some speculators may call themselves ‘property developers’, but they do little or nothing but profit from a bubble situation. Just to be clear, people who take out buy-to-let mortgages are also speculators, they differ from traditional landlords in that they must borrow to acquire property to let. This is obviously a risky practice and inflationary for property prices. The other notable problem class is those with meagre means being offered excessively easy terms to buy.
Property was bought with increasingly easy to obtain loans for increasingly tangential reasons; for example: buy-to-let property, holiday homes, weekend homes, university accommodation and just plain resale i.e. naked speculation. This combined with the demands of rapid immigration and a property supply that did not increase quickly enough, to cause unsustainable house price rises above wage rises. Housing, like pensions is too important to be used in that way, government should impose controls to prevent its misuse.
Some of this profiteering is long term, with people using it as a pension because of the poor quality pensions. The UK government does not provide a sound pension scheme, except naturally for themselves and other public sector workers. A good pension scheme should: be 100% underwritten by the state, have a guaranteed minimum growth rate, be contribution based, have a guaranteed minimum pension at the end regardless of contributions but based on time resident, be index linked, not be means tested, be ring fenced and protected by law. It seems the government believes that only the public sector are worthy of a good pension. They are, as ever, helping themselves.
So the causes seem to be increasing use of residential property as a means of speculation and pension savings combined with poor lending criteria. The problems only seem to have become visible when the inevitable increasing bad debt arranged with less financially solvent borrowers as mortgages on inflated property prices precipitated a collapse in confidence. That increase in defaulting was triggered by an increase in interest rates which were held low for a prolonged period to avert the worsening of the previous economic slowdown. During that period many poor loans were made that could never be sustained on a return to more normal interest rates.

What are the consequences of the problems

Debt is used as money i.e. the potential to recover money at a profit from loans is being treated as money. This works well enough if you know that the loan will be repaid with interest. Unfortunately, not all loans are repaid, some fail and money is lost, but as this is statistically at an expected level its effect of reducing the value of the rest of the debt can be taken into consideration. When that rate of failure jumps, confidence plummets in the value of the loans and they are less valuable alternatives to money. The loss in confidence in their own loans and those of other lenders who were similarly unwise, tends to restrict them from lending to all classes of borrower, including each other, to reduce risk. This has the effect of reducing the number loans made, how adventurous lenders are, how high the repayment rates are and how much collateral is required. Those changes in turn make it difficult for business to borrow for expansion and ride out problems and so employment and the greater economy suffers. Also, reduced borrowing by consumers slows spending, with the effect of reduced opportunity for businesses to profit from sales.
We may wish to consider the sustainability of economies built upon the premise of continuous growth in consumption. Large disparities in the relative sophistication of economic development must be sustained and the more sophisticated economies need to retain the perception that their economic model is best. If they fail in either part, people will stop pursuing the growth model. Debt has potential for significant further expansion providing lenders can consolidate to drive economies of scale and operate on tighter margins and apply pressure to keep interest rates low enough that borrowing is the only obvious route for many purchases.

What is being done to fix the problems

Firstly it is rather worrying and suspicious to me that the state / central banks seem to have been as blind to these problems as the money lenders claim they also were. Can they really be surprised that many years of house price growth above wage growth fuelled by low cost loans would lead to problems when interest rates rose. It seems so stupid that I would be quite credulous if a plot of grand proportions to profit under the guise of the credit crunch was revealed to me.
Anyway the government tactic to solve this problem is to get the state / central bank to lend money to the lenders. That should enable the lenders to keep trading, as their confidence of surviving problems is increased and the whole system stabilises. There are still a lot of loans that will take time to become worth what was lent, as property prices can take years to normalise, or they can be normalised quickly but catastrophically for some. Unfortunately, the government doesn’t have any money to lend, in fact it is itself a big borrower. So as neither has any immediate money the government has offered bonds (which currently are sufficiently sound to be considered as good as money) in exchange for quality debts of the lenders, proving certain guarantees are made. This is following the drawn out normalising process, rather than the rapid normalisation process. The former has the advantage of apparent stability in the short term, but the disadvantage of producing a tardy correction for the medium term and so slows the economy as a whole. The latter is better in the medium term as it affords all parties more time to recover, even the worst hit, but is worse in the short term for those in the worst positions and for general confidence if the effects are not well isolated. Both approaches will be equal in the long term as normalisation must occur.
One feels bound to ask here: who has the money. It seems that everyone is borrowing money, somebody must have some. An interesting question and to answer it one needs to remember that money is just a vector for production i.e. work done multiplied by efficiency; twice as efficient gives twice the production for the same amount of work. So the question should be: is there enough production to pay for the debt. One buys things with ones own productivity, but that includes recycling the productivity of others; specifically in creating the basic inputs to ones own work. If there were a finite amount of productivity in the world then clearly there could be no growth and so any debt should remain static. However, increasing populations and efficiencies, particularly in currently low technology economies, provide the continued growth in productivity. That is likely to continue and so debt levels can also increase, but they should not increase faster than the rate of increase in productivity.
Whether productivity is increasing or not, what level of debt can be sustained? Can it be as much or even more than the level of production? I think the answer to these questions is in confidence in the stability and predictability of the economy, markets and debt arrangements. As long as we have confidence that a debt will be repaid as arranged we can increase debt. If sufficient confidence exists then there is no reason why debt could not be arranged that could span whole lifetimes or even generations. The obvious inference from this is that we can have more debt than earnings, so long as we can sustain confidence in the stability and predictability of the economy, markets and debt arrangements. I would suggest that we are already in such a position and that explains the state / central bank conservative tactic of protecting the status quo as the least risky but otherwise least sensible option. Clearly a strategy for preventing the situation is preferable. That would imply a clutch of strong measures and checks to provide the required stability.

What are the consequences of this fix

Normally the government sells bonds to raise money. Bonds are a promise that the government will repay the money in the future; in the interim they will pay interest on the loan. The government (tax payer) must pay interest to the bond holders and in this case gets in exchange for those bonds another less reliable form of debt from the lender, rather than money and that makes the lenders more confident. Unfortunately, the country now owns the poor quality debt instead of money and is paying interest on it. In fact as we know the value of the mortgage debt the country has now acquired is over rated, not only is the country paying interest for these loans, it will have to wait years for them to be worth their face value. The net effect of all this is that the profits of the lenders in the bubble years have been protected by the government at the expense of the tax payer. Greater government debt must be paid for by taxation or cuts in services. Although this is a terrible deal for the people as a whole the government is essentially arguing that it is better than a collapse of financial institutions with potentially catastrophic ramifications. However, it may be that a better deal for the tax payer is a tactically managed collapse where the worst institutions are isolated and made to carry the whole burden.
A proper strategy to avoid us getting into this kind of situation would of course be preferable and that needs a slew of measure to check for abuses and imbalances. Unless such a system is put in place we face the probable repetition of this situation in the future.

Prognosis for the Economy

What is the prognosis for the economy?
There are three fairly obvious possibilities:
Firstly, some people think that most of the problems for the financial services have happened and so are we are near to a turnaround. This sentiment is evidenced by the current vacillating of the share markets.
Secondly, other people think that the financial services have precipitated a wider economic recession and now that will take over to drag down the economy into a deeper hole. As the economy is enabled by financial services that could certainly be true and consumer spending is changing, showing increasingly parsimonious spending patterns.
Thirdly, others believe that recent activities by central banks have staved off a potentially deepening crisis. Certainly, making more credit available to banks reduces the risks of further banking problems, which would pique the lack of confidence. However, has enough been done and are there other techniques that could be employed.

Which View is Correct?
The fact that the financial services sector was jointly at the heart of creating the problems and the fact that they are vacillating now over its depth means that they don’t have a clear vision of if we are at an economic low point, even though they are the ‘experts’. Central bankers seem to be at least as much in the dark as the financial services gurus, because they didn’t see the problems coming either. They have made increasingly strong efforts to avert a cascading of the problems into the wider economy and this indicates they too don’t know how far this will go. A preponderance of others have commented that they expect things to get worse before they get better. It would seem that the ‘clever money’ would be on a deepening of the current macro economic problems, exasperated by falling property prices along with rising food and fuel prices.
The full effects of problems on this scale do take time to ripple through an economy, so it is likely that even if we have reached the nadir of the original problems for the bankers, they may yet be revisited by their wider effects. So although none seems to have a full understanding of this problem plexus, we can expect the shockwave to ripple through the economy for some time. An important question is: will the after shock feed back to the financials strongly enough to initiate a new vanguard of problems.
My own view is that this crisis will deepen. Lending is constricted by tightening positions in financial services leading to tighter loan conditions. Many people have become comfortable with living at the edge of financial solvency and have started to find their newly restricted position forces them to cutback hard. This pruning of expenditure will denude businesses at marginal operational viability, which in turn will feed costs to the economy through unemployment. Fortunately, the businesses that are least viable and able to ride out a slowdown will tend to be small and although there will be a constant flow of them, they will have less of a confidence damaging effect than mass employers making redundancies. Also, people love to buy stuff and have a short memory for problems. As soon as their positions stabilise they will be back with what credit they can get and there will be creditors with money to lend. Further, service dominated economies are quicker to respond to demand, so for example the US and UK economies should bounce quicker than manufacturing based economies. Therefore, although I expect things to worsen, I also expect that they will flip back quickly to growth. Financial stability and solvency are less of a concern for many today and that combined with faster and more free flowing information than ever will resolve to a faster turnaround in the economy. We will soon return to the consumer dream, not because I want it, or think it is a good idea, but because most people want it. Given the desire for something and the opportunity for others to make money from that desire, there will be a race to make sure they get it, as soon as possible.

What should central bankers do?
Firstly, they must restore confidence. Confidence is the most important factor for a healthy financial services sector and central banks have moved to improve it. So much of the economic success of a country now depends upon its financial services sector that it must be unencumbered. Therefore, improving the stability of financial institutions with government backed loans is a possible scheme. However, this tardy tactic is essentially printing money and hence inflationary. Central banks know that the excessive valuations placed on residential property must be normalised. Price growth has exceeded wage growth and that leads to a bubble that draws in a disproportionate percentage of overall income to service that debt. This is not good balance and balance, after confidence, is most important. The central bankers should be encouraging the rapid normalisation of this over valuation to quickly restore parity. Drawing out normalisation will only delay the return to a balanced growing economy and I am concerned that a government statement about preventing people from losing their homes could do just that. They have not detailed how they plan to do this and it could be empty rhetoric, but if not and they start to intervene at this point they could stifle recovery for some time. An interventional strategy would have been much better to prevent the bubble. Intervention now should be to encourage a property market decline.
Secondly, they must address the root causes of the original crisis. They are manifold, but two stand out as significant: Excessive speculation using residential property, especially by people who do not understand investment markets. A poor pension system which encourages people to look for other ‘stable’ savings vehicles, in this case property investment was used.

What can we do as individuals?
As a general strategy, buck the trend. Be a saver when all about are spending big. The best time to spend big is when everyone else is not, you get the best deals then. Particularly, you should be looking at the big things: buying a house or moving to a better one, buying shares and a nice car at a bargain price. So, property will soon be a much better deal, shares already are, but will probably become better still and slightly used luxury cars will soon be everywhere at great prices. Simple really, just difficult to do.

Home ownership increases unemployment

The BoE MPC member Professor Danny Blanchflower points out that owning homes makes for a less mobile workforce and therefore tends to increase unemployment. Sounds plausible. So the implication is we make people more mobile by promoting home rental. Unfortunately people like to own their homes, so we could make business more mobile. It seems to me there was some promise to encourage businesses to move to the provinces quite some time ago by Tony Blair. It appears there was insufficient action on that one. I think some guaranteed periods of low and gradually increasing corporation tax combined with relocation advice might be a nice carrot. Perhaps a gradually increasing corporate tax rate for the highest density areas of business would provide a good stick.