The Unending British Deleveraging Cycle

Current estimates of what is known in the UK as the M4 money supply — cash outside banks, plus private-sector retail bank and building society deposits, plus private-sector wholesale bank and building society deposits and certificates of deposit — show a serious contrast between Britain and the United States:

UKvsUSM4

Could this divergence explain the strong divergence between UK and US real GDP?

RealGDP

I doubt it. It’s a chicken and egg question — does a prolonged deleveraging cycle explain real GDP weakness, or does real GDP weakness explain the prolonged deleveraging cycle? It may in fact be a self-reinforcing spiral effect where the first leads to the second and the second leads to more of the first, and so on. But there are a lot of other factors all of which may be contributing to the worsening situation — protracted weakness in business confidence, tax hikes, spending cuts, weak growth in the Eurozone, elevated youth unemployment, and uncertainty. All these factors are probably contributing to some degree to the weak GDP growth, and the prolonged deleveraging, and thus Britain’s depressionary economic condition.

But we can say that the difference cannot be that Britain’s monetary policy has not been aggressive enough. Britain’s monetary policy has been far more aggressive than that of the United States:

CB assets

How can we break the cycle? Well, as the above graph shows, more quantitative easing is unlikely to have a beneficial effect. The transmission mechanism is broken. What good is new money if it’s just sitting unused on bank balance sheets? What new productive or useful output can be summoned simply by stuffing the banks full of money if they won’t lend it?

The sad truth is that a huge part of the financial sector has failed. Its inefficiencies and fragilities were exposed in 2008, as a default cascade washed it into a liquidity crisis. And yet we have bailed it out, stuffed it full of money in the hope that this will bring us a new prosperity, in the delusional hope that by repeating the mistakes of the past, we can have a prosperous future.

The sad truth is that the broken, sclerotic parts of the financial sector must fail or be dismantled before the banks will start lending again, start putting monies into the hands of people who can create, innovate and produce our way to growth.

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Cameron’s EU Policy Uncertainty

So, David Cameron wants a referendum?

I believe that small is beautiful, and that the European Union system is big and fragile. I am all for free trade, freedom of movement and immigration. But as for regulatory, monetary and fiscal integration — which is the direction that Europe has taken, especially since the self-inflicted Euro crisis that grew out the fundamentally flawed Euro system — how can Europe be responsive to its citizens when they are so numerous, so diverse and so geographically and linguistically dispersed? How can it be viable to have the same regulatory and political framework for Poland, Spain, Austria, Britain, Denmark and Greece? Political and monetary frameworks that are local and decentralised are usually responsive and representative. Big bureaucratic juggernauts are very often clunky and unresponsive.

That means that I am quite open to the idea of Britain leaving the political union, so long as we retain the economic framework that Britain voted for in a referendum on joining the European Economic Community — the predecessor to the European Union — in the 1970s. Britain never voted for political union, and the British public has been shown again and again in polls to be broadly against such a thing.

But David Cameron’s plan for an In-Out referendum in 2017 — but only if the Conservatives win the 2015 election — is misguided. It will just create five years of totally unnecessary policy and regulatory uncertainty.

There is empirical evidence to suggest that policy uncertainty can be very damaging to the economy. A 2013 paper Scott Baker, Nicholas Bloom, and Steven Davis used automated text analysis techniques to count key words relevant to uncertainty in the media. They combined the news analysis with data from tax code changes, disagreement among economic forecasters, and information from equity option markets to create an “uncertainty index”:

UncertaintyIndex

They looked at changes to gross domestic product, private investment, industrial production and unemployment, and found that spikes in uncertainty foreshadow large and persistent declines in all four. First, GDP and private investment:

GDPInvestment

Next, industrial production and unemployment:

Policshocks

The last thing that Britain needs is five years of policy uncertainty. If Cameron wants to have a referendum on E.U. membership, why not do it now? 82% of the public favour such a referendum — presumably not only UKIP and Conservative voters, but also Liberal Democrats and Labour voters. If we vote to leave, then we leave, if we vote to stay, we stay. We — and the markets — will know exactly where we stand.

Frankly this strikes me as more of a political ploy. The Conservatives are haemorrhaging support to UKIP. They are roughly ten points behind Labour in the polls. This strange announcement just seems like an attempt by Cameron to claw back support and distract from the disastrous state of the economy which just entered a triple-dip recession and which has been depressed since 2008. Ironically, this announcement may actually worsen the economic woe.

George Osborne Cuts His Own Welfare

George Osborne, the Chancellor of the Exchequer, a man whose salary totals £134,565 receives government welfare.

But he claims he is about to give up the dole in the interests of fiscal sanity.

In an Op Ed in the Daily Mail Osborne writes:

This week my family will not receive the child benefit we’ve been getting every week since our children were born. Any household where at least one member is earning more than £60,000 will be in a similar position.

They can either choose to stop receiving child benefit, as we have done, or they can have the equivalent sum taken away through the tax system later.

Those earning between £50,000 and £60,000 will lose a portion of that child benefit cash.

It’s not an easy decision we’ve taken as a Government – these days, there aren’t any easy decisions.

Osborne’s claim is that only through contracting spending can we reduce the deficit, and only be reducing the deficit can we have a brighter future. He couldn’t be more wrong.

While it is absurd that rich men like Osborne receive child benefit that they don’t need while severely ill and seriously disabled individuals are thrown off welfare and told they are have to find work (even though unemployment is already elevated, with eighteen people applying per vacancy in 2012, so just how disabled and sick people are supposed to find work in such a depressed economy is quite a conundrum) this is merely a side issue to the wider folly of Osborne’s economic policies.

Balancing a government budget is not simple arithmetic like balancing a household budget. The two policy tools typically discussed in dealing with deficits — cutting spending, and hiking taxes — have powerful hidden effects that often (paradoxically) make deficits bigger, as has happened in the case of the extreme austerity in Greece.

If spending on welfare is cut, then the income of those who would have received that spending is cut, in turn cutting the incomes of others — shops, manufacturers, service-providers — who could have otherwise sold things to them, cutting the incomes of their suppliers, and so on.  And the government will also lose any tax revenues that would have been paid, shrinking revenue and leading to bigger deficits.

If taxes are hiked, then not only does this shrink disposable income — leading to a similar contractionary effect as welfare cuts — but it also leads to Laffer-curve-style tax avoidance, as those subjected to higher tax rates move their income offshore, and use loopholes and creative accountancy to avoid paying taxes. This too can actually drink revenue and lead to bigger deficits.

The better option is to stop trying to balance the budget using contractionary budget cuts and tax hikes and instead focus on increasing output and decreasing unemployment by growing the economy. If the economy grows significantly, and government spending remains the same, then the budget deficit will by definition close itself (and the welfare bill will by definition shrink as more people find jobs). Although the capital markets are offering governments the ability to borrow at very low rates, there is really no straight binary choice between debt-fuelled stimulus and austerity. Policies that promote growth are possible without adding a penny of debt.

  1. Attract more foreign capital into Britain — there are trillions of dollars of foreign capital in emerging markets like the middle east, Russia and China. Britain could offer British citizenship and other incentives for citizens of foreign countries that invest in the UK. Foreign capital can be used to improve British infrastructure, like improving the road, rail and broadband networks, which will in turn provide new jobs.
  2. Increase entrepreneurship — use the bailed-out part-nationalised banks as a vehicle to offer business startup loans to unemployed people. There are millions of jobless people who want to work or a start a business, but cannot because of credit conditions and the weak job market.
  3. Deregulate small business — decrease the regulatory and tax burden for new businesses. Make it easier and simpler to achieve planning permission to build new homes.

Indeed, the current government has paid lip-service to some of the above, but with few tangible results. Britain’s difficult immigration laws continue to deter foreign investment. Four years after the bailouts and in spite plenty of promises from the government, the banking sector is still not lending to small business. The overwhelming thrust of the government’s policy has been contractionary austerity. And the overwhelming result has been weakness and contraction:

uk-vs-us-real-gdp-in-current-downturn

If Cameron and Osborne don’t change their strategy — move away from trying to cut absolute government spending, and move toward trying to boost the wider economy, and so cut government spending as a percentage of GDP, then the economy is highly likely to stay depressed.

And that would be a cut to everyone’s welfare.

The Interconnective Web of Global Debt

It’s very big:

article-2118152-124602BE000005DC-0_964x528

Andrew Haldane:

Interconnected networks exhibit a knife-edge, or tipping point, property. Within a certain range, connections serve as a shock-absorber. The system acts as a mutual insurance device with disturbances dispersed and dissipated. But beyond a certain range, the system can tip the wrong side of the knife-edge. Interconnections serve as shock-ampli ers, not dampeners, as losses cascade.The system acts not as a mutual insurance device but as a mutual incendiary device.

A mutual incendiary device sounds about right.

Mark Carnage

The greater story behind Mark Carney’s appointment to the Bank of England may be the completion of Goldman Sachs’ multi-tentacled takeover of the European regulatory and central banking system.

GS1

But let’s take a moment to look at the mess he is leaving behind in Canada, the home of moose, maple syrup, Jean Poutine and now colossal housing bubbles.

George Osborne (who as I noted last month wants more big banks in Britain) might have recruited Carney on the basis of his “success” in Canada. But in reality he is just another Greenspan — a bubble-maker and reinflationist happy to pump the banking sector full of loose money and call it “prosperity” before the irrational exuberance runs dry, and the bubble inevitably bursts.

Two key charts. First, household debt-to-GDP.

household-debt-to-gdp-chart-canada

Deleveraging? Not in Canada.

The Huffington Post noted earlier this year:

Household debt levels have reached a new high, increasing the vulnerability of average Canadians to unexpected economic shocks just at a time when uncertainty is mounting.

Despite signs that Canada’s economic recovery is fizzling, data released by Statistics Canada Tuesday shows that the ratio of credit market debt to personal disposable income climbed to 148.7 per cent in the second quarter, surpassing the previous record of 147.3 per cent set in the first three months of this year.

Second, Canadian house prices:

2001-after-years-of-moving-sideways-home-prices-took-off

Famed analyst Jesse Colombo recently wrote:

Booming commodities exports and skyrocketing housing prices are encouraging Canadians to spend far beyond their means, while binging on credit, mimicking their American neighbors’ profligate behavior of six years earlier. (They’re thinking, “Canada is different!”) RBC Global Asset Management’s chief economist warns that Canada’s record household debt could “spell its undoing,” while Moody’s warns that Canadian banks face significant risk due to their exposure to overleveraged Canadian consumers. Maybe things really are different in Canada, where a group of under-21-year-olds got caught by the police for racing $2 million worth of exotic supercars, including Ferraris and Lamborghinis. Or not.

The age-old misperception that this time is different, that Chinese investors will continue to spend millions on crack shacks in Vancouver, that an industrial boom in East Asia will continue to support demand for Canadian commodities, that Canada’s subprime slush isn’t vulnerable, that hot inflows from capital rich low-interest rate environments like Japan and America will continue forever.

In the short term what is going on is that the ex-Goldmanite Carney has pumped up a huge bonanza of securitisation and quick profits for big banks and their management who are laughing all the way to the Cayman Islands (or in Carney’s case, Threadneedle Street). Once the easy money quits flowing into the Canadian financial system from abroad, defaults will begin to accumulate, cracks will quickly appear, and Canada will spiral into debt-deflation. Taxpayers in Canada (and in other similar cases like Australia) may well end up bailing out the banks profiting so handsomely now, just like their American and British and Japanese cousins.

The appointment of Carney is a disaster for Britain and a disaster for the Bank of England. Carney has already singled out Andy Haldane for criticism, an economist at the Bank of England with a solid understanding of the dynamics of complex financial systems, and a champion of simple and clear regulation. 

In a hundred years, people may be taking out zero-down mortgages against building geodesic domes on Mars or the Moon, and flipping them off to greater fools for huge profits. Because this time is different, right? And another crash and depression will follow.

George Osborne & Big Banks

The Telegraph reports that George Osborne thinks big banks are good for society:

The Chancellor warned that “aggressively” breaking up banks would do little to benefit the UK and insisted the Government’s plans to put in place a so-called “ring fence” to force banks to isolate their riskier, investment banking businesses from their retail arm was the right way to make the financial system safer.

“If we aggressively broke up all of our big banks, I am not sure that, as a society, we would benefit from it,” he said. “We don’t have a huge number of banks, sadly, large banks. I would like to see more.

His comments came as he gave evidence to the parliamentary commission on banking standards where he was accused of attempting to pressure members into supporting his ring-fencing reforms.

“That work has been accepted, as far as I’m aware, by all the major political parties. We are now on the verge of getting on with it,” he said.

Several members of the Commission have argued in favour of breaking up large banks, including former Chancellor, Lord Lawson.

This is really disappointing.

Why would Osborne want to see more of something which requires government bailouts to subsist?

Because that is the reality of a large, interconnective banking system filled with large, powerful interconnected banks.

The 2008 crisis illustrates the problem with a large interconnective banking system. Big banks develop large, diversified and interconnected balance sheets as a sort of shock absorber. Under ordinary circumstances, if a negative shock (say, the failure of a hedge fund) happens, and the losses incurred are shared throughout the system by multiple creditors, then those smaller losses can be more easily absorbed than if the losses were absorbed by a single creditor, who then may be forced to default to other creditors. However, in the case of a very large shock (say, the failure of a megabank like Lehman Brothers or — heaven forbid! — Goldman Sachs) an interconnective network can simply amplify the shock and set the entire system on fire.

As Andrew Haldane wrote in 2009:

Interconnected networks exhibit a knife-edge, or tipping point, property. Within a certain range, connections serve as a shock-absorber. The system acts as a mutual insurance device with disturbances dispersed and dissipated. But beyond a certain range, the system can tip the wrong side of the knife-edge. Interconnections serve as shock-ampli ers, not dampeners, as losses cascade. The system acts not as a mutual insurance device but as a mutual incendiary device.

Daron Acemoglu (et al) formalised this earlier this year:

The presence of dense connections imply that large negative shocks propagate to the entire fi nancial system. In contrast, with weak connections, shocks remain con fined to where they originate.

What this means (and what Osborne seems to miss) is that large banks are a systemic risk to a dense and interconnective financial system.

Under a free market system (i.e. no bailouts) the brutal liquidation resulting from the crash of a too-big-to-fail megabank would serve as a warning sign. Large interconnective banks would be tarnished as a risky counterparty. The banking system would either have to self-regulate — prevent banks from getting too interconnected, and provide its own (non-taxpayer funded) liquidity insurance in the case of systemic risk — or accept the reality of large-scale liquidationary crashes.

In the system we have (and the system Japan has lived with for the last twenty years) bailouts prevent liquidation, there are no real disincentives (after all capitalism without failure is like religion without sin — it doesn’t work), and the bailed-out too-big-to-fail banks become liquidity sucking zombies hooked on bailouts and injections.

Wonderful, right George?

Inflation Around the World

Certainly, inflation rates may be manipulated downward in all countries to hide the inflationary effects of money supply expansion. But comparing nations to one another does give us some idea of which nations have some semblance of price stability.

So, it’s more bad news for Britain and for David Cameron. Not only do we have lower GDP growth than America and higher unemployment, we also have higher inflation. And — if you can believe it — higher than Zimbabwe.