Record recession for UK economy

Britain’s economy contracted unexpectedly in the third quarter of this year, quashing hopes that the downturn was ending and instead marking the country’s longest recession since records began in 1955.

Sterling plunged more than a cent against the dollar and government bond futures surged as traders and analysts bet the Bank of England may now have to expand its quantitative easing programme to secure a recovery.

The figures are a blow to the ruling Labour government, trailing in opinion polls and hoping for a recovery to take hold well before an election due by next June.

The Office for National Statistics (ONS) said British gross domestic product (GDP) fell by 0.4 per cent between July and September, meaning the economy has contracted for six successive quarters for the first time for more than five decades.

‘Awful’ figures

The data was much worse than analysts’ expectations of a 0.2 per cent rise, with not a single analyst out of the 35 polled by the Reuters news agency having predicted a negative reading.

“Third quarter GDP is awful, with no positive news within the report,” said James Knightley, an economist at ING, a Dutch bank.

“More worryingly from sterling’s perspective is the fact that the UK may be the only major economy to have contracted in the third quarter.”

The length of the downturn could prove an embarrassment for Gordon Brown, the prime minister, particularly as Germany and France are already out of recession.

Alistair Darling, Britain’s finance minister, said he still believed the economy would return to growth by the end of the year, reiterating a forecast made in the budget in April.

Darling will update that forecast in his pre-budget report which is due in the next few weeks.

“We’re facing the worst global financial crisis and recession in 60 years,” he said.

“We’ve always said that we remain cautious as a result of the high degree of economic uncertainty.

“That’s all the more reason to continue the action the government is taking. To remove it now would be madness.”

Services weak

Year-on-year, output shrank by 5.2 per cent, only marginally better than the record 5.5 per cent annual fall registered in the second quarter.

The quarterly decline between April and June was unrevised at 0.6 per cent.

The ONS said there had been a peak-to-trough GDP fall of 5.9 per cent during the current recession, compared to six per cent between the second quarter of 1979 and the first quarter of 1981 – a period when there were some quarters of growth.

Analysts had been pinning their hopes for recovery on months of survey evidence that had pointed to a sharp rise in confidence and activity in the services sector, which makes up three-quarters of Britain’s economy.

“What is most striking is the still-weak contribution from the services sector,” said Stephen Lewis, an economist at Monument Securities.

Services contracted by 0.2 per cent over the quarter, with the distribution, hotels and catering sub-sector leading the decline with a one per cent quarterly drop.

Economists had already expected industrial output to be weak, following a sharp monthly drop in August, and the GDP data bore this out.

Industrial production fell by 0.7 per cent over the quarter, taking its annual decline to 10.4 per cent.

THE DYNAMICS OF THE GOLD & SILVER MARKETS?….EXPLOSIVE!

Adrian Douglas

This week gold closed above $1000/oz for the fourth consecutive week and made another all time weekly high close. But the top-callers have come out in their droves declaring that gold is in a bubble that is about to burst, and because the recession has been declared as over there is no reason to hold such a safe-haven asset. All that is nonsense and I will explain why. The dynamics unfolding in the gold and silver markets are nothing short of explosive.

The dynamics are different for gold and silver so I will start by discussing gold.

Gold is a unique substance. It is about the only thing on the planet that is bought and stored and never consumed. Almost all the gold ever mined in history still exists above ground. The purpose of gold is to act as a store of wealth. This singularity of gold makes it susceptible to a scam that was first perpetrated by the goldsmiths in the 16th century. The goldsmiths realized that customers would buy gold and leave it for safe keeping in their vault. This meant that they could show the same gold bar to many customers and sell the same gold bar many times over. This was the early form of the concept of fractional reserve banking where banks only retain 10% of the money on deposit gambling that no more than 10% of the money will ever be called upon to be paid out.

This basic scam is at the center of modern gold market manipulation. Paper substitutes for gold are sold instead of real gold through derivatives, futures, pooled accounts, ETF’s, gold certificates etc. I estimate that each actual physical ounce of gold has been effectively sold 20 times over or more. To be able to maintain this Ponzi scheme some real gold is required because some investors or jewelers demand real gold. For the scam to be sustained there must always be plentiful physical gold for those who want it. This physical supply has been met from mine supply and central bank leasing and selling. The market is in effect a giant inverted pyramid with a huge paper gold market being supported above a small amount of physical gold at the tip of the inverted pyramid. The scam can continue until there are indications of a shortage of physical gold. If the twenty or so claimants of each oz of real gold demand their gold then there is the potential for a squeeze like has never been seen before in history.

To lend support to the idea that all the gold in the world has been sold several times over I cite the case of Morgan Stanley who were sued in 2005 for selling non-existent precious metals to their customers. They even had the audacity to charge storage fees! They settled the class action suit out of court but no criminal charges were ever filed against them. If Morgan Stanley was doing this you can bet that it is the tip of the iceberg. As further evidence just look at the monster OTC derivatives market. Standing at approximately $1,000 trillion it is multiples of the liquidated value of all the assets in the world and all currency in the world. Clearly derivatives must be selling some sort of claims to assets that can not be fulfilled because there are not enough underlying assets.

The price discovery of gold has been almost exclusively achieved through the shuffling of paper gold promises between investors and bullion banks on the COMEX with very little real gold ever changing hands. The situation is changing. Some big entities are now demanding physical gold. These entities are almost certainly countries not individuals, such as China, Russia, India, Venezuela, Iran the Gulf States to name but a few. This demand for real gold, instead of paper substitutes, is putting a strain on the gold market. Paul Walker, CEO of GFMS, recently said the price of gold was going up because of “large lumpy transactions in a market with a degree of illiquidity”. Roughly translated this means that there are large demands for physical metal which the market is struggling to meet. That is a Cartel apologist’s limp wristed reference to the explosive dynamics that I am defining!

The supply that feeds the bottom of the inverted pyramid to support the gold price suppression via a paper market is drying up. Mine supply has been declining for almost a decade and this year central banks became net buyers of gold for the first time in 20 years. The stress in the physical market is starting to show to those who are paying attention. For example, the London PM Fix is coming in at historic highs day after day, the contango in the futures market has contracted dramatically, the US mint is routinely suspending production due to shortages of metal. But most importantly we are seeing astute investors display a growing preference for real bullion. A couple of months ago Greenlight Capital, the large hedge fund, switched $500 million of investment in GLD to physical gold bullion. The supposed gold holding of GLD has not grown to a record high despite a record high gold price. Apparently Germany has requested that its sovereign gold held by the NY Federal Reserve Bank be returned to Germany. Hong Kong has requested the same of the Bank of England that stores its sovereign gold. Robert Fisk, a respected journalist for the UK’s Independent newspaper, reported this week that the Arab oil producing states, Japan, Russia and China have been holding secret talks to replace the dollar as the international reserve currency and as an accounting unit for trade. He reports that the basket of currencies they propose instead of the dollar would include gold! If gold is going to regain its monetary role then you can understand why those in the know want actual physical bullion. There are some very real and significant signs that a run on the bank of the Gold Cartel for physical gold is commencing.

Meanwhile most investors and analysts are focused only on the net short position of the Commercial traders on the COMEX which has reached an historically high level, and has in the past signaled the onset of a major correction. However, such market observers are only watching a side-show of the main event. The main event is all about a growing tightness in supplies of gold in the physical market. I don’t think the Commercial net short position of 800 tonnes is that important; what is important is that the world’s stockpile of 140,000 tonnes may have been sold several times over. In all likelihood half of the supposed 30,000 tonnes of Central Bank stockpiles have been sold at least 20 times over. The gold short position could well be 300,000 tonnes (15,000 times 20) against a total world inventory of only 140,000 tonnes, much of which is not available to the market. Could you think of a more bullish scenario? If you think that such business practices could not be tolerated I can hold up the example of the airlines who regularly and knowingly oversell the seats on their flights expecting that not all passengers will show up. Bullion bankers oversell their inventory of gold knowing that only 10% of the customers will ever ask for it, just as the goldsmiths did.

One can not discuss the gold market in isolation as it is linked to the dollar and Treasury debt. The major impetus behind the suppression of the gold market was to maintain a strong dollar despite massive over-issuance of the currency. This has allowed the US to live beyond its means because the rest of the world accepts the home-made funny money as payment for goods and services! Lawrence Summers, in a study he made when he was a Professor of Economics at Harvard titled ‘Gibson’s Paradox and the Gold Standard” showed that in a free market gold and real interest rates move inversely to each other. However, since 1995 the US has had low gold prices and low interest rates. In the absence of a Gold Standard this could only have been achieved by surreptitiously fixing the gold price through market manipulation. This was the essence of the “strong dollar policy” of Robert Rubin, the mechanism of which was never explained to the public.

The dynamics of the silver market are different. About 90% of physical silver production is used for industrial applications. Only 10% is purchased for investment. Clearly paper substitutes for silver can not be used in industrial processes. The investment market is suppressed by paper silver substitutes as described above with respect to the gold market. It is this market, specifically the COMEX futures exchange, which controls the price of silver. The very low price of silver over the last 30 years has encouraged large holders of silver to dishoard it. After all, who wants to pay costly storage fees for something that is of low and declining value and very bulky to store? This dishoarding has filled the gap between silver production and industrial demand which runs at over 200 million ozs annually. Much of the investment demand has been met with paper substitutes and scams that are variations on the one that was perpetrated by Morgan Stanley described above. Because of the suppression of the price of silver it has been uneconomic to recycle most industrially used silver, with the exception of that used in the photographic process. This has meant that most industrially used silver finds its way into land fills. All the existing above ground silver is now less than 1 billion ozs. Considering that just SLV ETF alone claims to have over 250 million ozs of silver it is reasonable to estimate that investors have been sold something of the order of 5 billion ozs of silver. But how much is supported by real physical silver? If the same oz of silver has been sold 20 times over, as per my estimate in gold, then only 250 million ozs of investment silver bullion exist. This means that 4.75 Billion ozs of silver could potentially be demanded in a market where only 1 billion ozs of stock pile exists and mining supply is already oversubscribed to the tune of 200 million ozs annually. One can probably add to this picture that investors who can not easily find physical gold will come looking to buy physical silver. What is even more bullish is that the industrial users will not sit idly by watching a manic silver grab. They will join in the fray because they can not remain in business unless they have silver inventory. They will try to stockpile at a time of acute shortage.

The dynamics of the gold and silver markets are bullish beyond anyone’s wildest dreams. This is no longer about whether the commercials will knock down the price by selling more contracts short. This is about a lot of market participants who have been content in the past to hold precious metal paper substitutes who now increasingly will want to own real bullion. This has been happening slowly but will gather pace like a rolling snow ball. Because in the last 30 years most investors have trusted the brokers, dealers and bullion banks to actually have the metals that have been sold there has been no “run on the bank”. This is now changing. Many indications point to significant supply stress building.

Why are the entities that hold the largest short positions on the planet custodians of the bullion depositories for the largest ETF’s? That’s like putting a sex offender in charge of the Children’s Day Care Center or Bernie Madoff in charge of your company pension fund! The argument against holding physical bullion yourself has always been the risk it might get stolen while in your possession. However, the risk of holding bullion substitutes might be that it has already been stolen or never existed!

The precious metals market is now akin to a game of musical chairs with perhaps only one chair for every 20 players. It might be prudent to follow in the footsteps of Germany, Hong Kong, China and Greenlight Capital and get your chair BEFORE the music stops.

If the physical markets for precious metals lock up due to shortages then the short squeeze will be of epic proportions; it will be something to tell your grand children about. Needless to say it will be a better story for your grandchildren if you are on the right side of the trade!

Adrian Douglas
October 9, 2009

Big Four Face Unlimited U.K. Negligence Claims

By Michael Cohn

September 29, 2009

The Big Four audit firms in the United Kingdom are worried that they could be facing huge payouts for negligence claims in the wake of the financial crisis and even the potential collapse of some firms.

The U.K. member firms of Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers have been pushing for a cap on payouts from negligence lawsuits, but did not receive the legal change they wanted from the U.K. government. They had been making their case to Business Secretary Lord Mandelson and the Department for Business, Innovation and Skills, according to Times Online.

Under current law, the audit firms can be held liable for the entire amount of losses when one of their business clients suffers a financial collapse, even if they’re only partially at fault. The firms are worried that lawsuits arising from audits of the Madoff feeder funds and companies like New Century Financial could even bankrupt them.

While Lord Mandelson is reportedly sympathetic to their concerns, his department apparently already considers a recent legal change to be enough of a help to the firms. The 2006 Companies Act gives company directors the ability to limit the liability of auditors if they get the approval of shareholders. However, this law does not go far enough from the audit firms’ perspective as no major companies to date have been willing to limit their audit firms’ liability.

Go to Article

Cash for Clunkers -and- Bernanke “Saving the World”

More economic wisdom from Chris Gaffney and Chuck Butler…

Should be a busy week ahead, and I would expect for most of the data out of the US to continue to confirm a government led recovery is underway here in the US.  In particular, the consumer spending and durable goods orders should show a nice uptick on the back of the cash for clunker program.  But Chuck sent me a note over the weekend which questions the ‘success’ of this program.  Is it really what the US economy needed?  Here are Chuck’s thoughts from San Francisco:
 

“I was sitting here thinking about something that had flashed across the TV screen here in my room, and that is the “Cash for Clunkers” program… I blasted this program two weeks ago, and now that it’s finally done with and $3 Billion was spent to artificially boost auto sales, I will put my final thought on this… Of course I already talked about the obvious things wrong with this program. But here’s my final thought, and that is… I believe the program is going to end up hurting the most vulnerable consumers in the U.S. Middle Class buyers, traded in their “paid for” cars, and leveraged up to buy a new car, when they probably shouldn’t have done so, given the rot on the economy’s vine.

So… Once again, I’m reminded of the words that President Reagan said were the scariest words that could be spoken… “I’m from the government, and I’m here to help”…

The reason I’m all over this program today like a cheap suit, is that this weekend, I heard that Big Ben Bernanke made a claim at the Jackson Hole boondoggle, that “we saved the world”… Oh, Come on Big Ben, isn’t that just a bit dramatic? Does this statement have anything to do with the fact that you are up for re-appointment in January, and you would love to have that thought of you “saving the world” on the minds of the administration?

So… In the end, we’ll see if “he saved the world”…”

I’m with Chuck on this one.  It seems the US government is intent on getting consumers to go back to their borrow and spend habits.  This is what created the bubbles, and the administration seems intent on creating another bubble economy.  US consumers have made some historic cut backs on the amount of debt they are amassing (whether or not these cutbacks are by choice).  The US government should not be encouraging these consumers to go back to their previous ways, but should instead be trying to use the funds to educate and train consumers and to encourage new and innovative companies.  Use this downturn to correct some of the bad habits which we had gotten into.  Yes, it will be painful, but breaking an addiction is always hard and painful.  US consumers need to break our addiction to easy credit and massive debt.  This recession/depression has given consumers a much needed wake up call, hopefully the administration won’t be able to push consumers back into their old habits.

I went running with my wife and her friends over the weekend (trying to take it easy on the back) and got into a discussion about the US economy.  One of my wife’s friends had heard an interview on MSNBC in which an economist stated we were in a classic V shaped recovery.  I let her know that I think the economist was one letter off, and that instead we will see the recovery shaped more like a W.  The green shoots and recovery we are seeing right now will die out as government stimulus slows.  High unemployment, a long slow housing recovery, commercial real estate woes, and rising personal bankruptcies will force the economy into another dramatic downturn.  Central banks who have ‘juiced’ their economies with unlimited credit will have to decide whether to continue juicing, or pull back from the table.

Nouriel Roubini wrote a commentary in today’s Financial Times which agrees with my thoughts.  Roubini said the chance of a double dip recession is increasing because of risks related to ending global monetary and fiscal stimulus.  He believes the global economy still has further to fall, and will bottom out sometime during the second half of 2009.  While some economies such as China, Germany, Australia, and France will likely recover; others such as the US and UK will double dip with another leg down.  “There are risks associated with exit strategies from the massive monetary and fiscal easing,” Roubini wrote.  “Policy makers are damned if they do and damned if they don’t.”

What risk of Deflation?

Neville Bennett

The price level in the UK was the same in 1815 and 1914. This did not mean that prices were stable throughout that 100 year period: they fluctuated in long waves, with periods of inflation followed by deflation. More recently, there was a decade of deflation at the time of the Great Depression, and in Japan prices fell by an average of 0.5% p.a. from 1999-2005.

Deflation may again affect the US and UK, and perhaps spread further through the world economy. Consumer prices slipped by 2.1% in the year to July in the US, and 0.7% in the EU. In the UK the CPI is expected to be 1.8%, despite the Bank of England and Government desperately trying to keep it at above 2% by cutting interest rates to their lowest level in 300 years and pouring ₤150 billion into financial markets, a sum more than 12% of GDP.

The UK’s CPI does not contain housing costs, the Retail Price Index is more inclusive and it indicates that the UK had a -1.6% fall in prices for the July year: its first fall since 1960. I believe deflation is already strong in the UK as goods have declines in price since about 1995, but services have lifted the CPI.

There is widespread fear that the massive pump-priming by Governments globally will be over-inflationary, but I question that because it will result in higher interest rates, higher government spending on debt service and lower spending on welfare, increased taxes and higher costs to business for credit. Japan has tried for 19 years to create inflation but has failed. Moreover, there is a huge ‘output gap” putting pressure on all producers.

I do not intend, however, to gaze into the crystal ball so much as to discuss deflation and explain some its properties.

What is it?

Deflation is simply a fall in prices, and is regarded negatively because it is associated with depressions and with very low interest rates. The UK has not had a full year of deflation since the 1930’s. Indeed, inflation has been the norm, averaging 7%, since 1945.

Conventionally, deflation has virtues: consumers enjoy falling prices creating increases in real wages (the Great Depression was good for people in work). Moreover, it causes low interest rates, yet it is good for savings as their real value increases annually.

Deflation is not so good, therefore, for people in debt. The value of real debt increases each year, which affects people on mortgages as their house or farm may also decrease in value each year. It also discourages spending because the prices will be cheaper next year. Wages fall creating a downward spiral. It damages banks because they end up with a lot of surrendered property. The BNZ was the biggest landowner in New Zealand in the early 1890’s.

Recent Research

A recent Bank of England study by Groth and Westaway [Groth} discusses deflation’s costs in detail. Price adjustments for firms are costly, both for reprinting price lists but more in setting optimal prices in an environment of changing prices. Zero inflation is preferable. Deflation has an effect on taxation. In most cases, tax systems are not inflation indexed, so taxes rise with inflation.

The argument that consumers will defer consumption in periods of deflation is challenged by Groth and Westaway. They argue that in most cases low interest rates weaken the case for postponement.

Wages

Groth also discusses the difficulty of business in reducing money wages when this is justified by economic conditions such as the distressed situation of a firm or when all prices are falling. Workers may have a “money illusion”: they might focus on nominal wages rather than real wages. It they have a money illusion; they will resist a wage cut because they think they can buy fewer goods.

Many workers may resist pay cuts, not because they have a money illusion, but because they want to be rewarded for increasing productivity. British workers have raised productivity by about 2% a year over the last 30 years, so even if prices fall, there would not generally be a necessity (in the short-term) to cut in nominal wages. But in some industries, especially those particularly hard-hit, there would be a stronger case for wage cuts. If these are resisted, it can increase unemployment.

What evidence is there for downward rigidity in wages? Certainly there are more raises than cuts. But I believe many employees are prepared to accept cuts when there is a strong case. Most economists believe there is strong resistance, but this is exaggerated by the actions of a few trade unions. Employers find ways of cutting labour costs, moreover, by slashing non-wage benefits and bonuses, avoid customary raises for merit or seniority, or employing new workers at lower wages than those paid to existing workers.

In the UK there are a growing number of wage freezes, while wage cuts are relatively few. But British Chambers of commerce data indicates that about 10% of companies plan nominal cuts in 2009. Workers may be more flexible than they have been in the previous inflationary periods because they perceive growing unemployment: a lower-paid job is better than the dole.

Debt Deflation

Deflation increases the debt burden and recessions are deeper for countries carrying the most debt. The key element is a transfer of wealth from debtors to creditors caused by an unexpected fall in inflation. Many mortgage holders expected benevolent inflation. About 40% of Britons entered fixed-rate contracts and are now suffering from a real rise in interest rates. This effect is magnified by falling employment and a fall in asset values. Defaults will rise and impact on financial institutions.

The authors say many writers have demonized deflation but it is important not to confuse the effects of the credit- crunch shock with the effects of deflation itself. Goth says British workers are flexible about wages. She believes that with a massive monetary policy response, the deflationary episode should be short-lived. My knowledge of the Japanese economy makes me skeptical of that conclusion.

Blair bank targeted in £8.5bn FSA probe

JP Morgan Chase, whose chief executive Jamie Dimon last year recruited the former prime minister as an adviser, is being investigated by the City’s watchdog, the Financial Services Authority for allegedly failing to keep track of £8.5bn of clients’ money.

The FSA has called in a top firm of accountants to examine the bank’s London activities after evidence emerged that JP Morgan had mixed customers’ funds with its own.

Banks are meant to maintain a strict segregation of their own money from that which is held on behalf of clients.

But JP Morgan managers in London discovered last month that client and bank money used for trading futures and options – a way of speculating on movements in currencies, share prices and commodities – had apparently been put into a single pool.

Link to article:

http://www.thisismoney.co.uk/markets/article.html?in_article_id=489457&in_page_id=3

The Economy: Glimmers of Hope in The Darkness

By Al Walsh

Although this pervasive recession/depression continues to hang over us, and I believe the worst is yet to come, there are small positive signs.  Following is a recap of recent observations; many of which I’ve previously shared:

• Commercial credit is showing signs of loosening up – although the “jury is still out” as to who will qualify.
• Durable goods orders are up – indicating some positive stirrings in industry.
• Housing sales are marginally up – although I expect more “dark days” ahead as people use up their unemployment benefits and more mortgage resets occur.  I’ve heard talk of Washington extending unemployment benefits further, which may help matters if they go through with it.
• Businesses have begun receiving federal funds for energy development.  So far, most of the money has gone to big business.  Not much help to entrepreneurs, but good for jobs and business in general.  Smaller companies may receive some indirect benefits via subcontracts from the major recipients.
• The “cash for clunkers” program is popular, spurring auto sales.
• The stock market’s shown signs of life, although I expect dangerous volatility ahead.
• Imports are marginally up, indicating some “fresh breath” in consumer spending.  This will help the shipping lines and common carriers.
• Headhunters I talk to tell me that they’re starting to see some increased hiring action. Nothing to get excited about yet; but a start.
• Consumer saving is on the rise.  The saving rate has been dangerously low for way too long.  The funds deposited with banks should help marginally ease the credit freeze by providing a base for new lending.  Let us hope the banks don’t just sit on it, like they did with the bailout money.
• The rate of IPOs (Initial Public Offerings) is slightly up, providing a positive sign that investment capital is starting to “come out of the woodwork”.
• Industry in general reduced inventories drastically; a mixed-blessing but one that provided cash flow for survival and which will provide a platform for ramped-up production as we come out of the recession/depression and demand increases.
• Consumers are going through the painful process of deleveraging from the high credit positions they’ve been in for years.  Of course many without jobs are increasing those positions for survival, but in general the nation is going through a forced shedding of some credit burden; which is a good thing.
• Other nations are starting to see signs of recovery, including the UK and China.

None of these factors are of great significance themselves, but together they offer some rays of hope.

Economics in Crisis

Economics in Crisis

Neville Bennett
July

Ben Bernanke told a town-hall-style meeting in Kansas this week that he was not going to “preside over the second Great Depression”. Dr. Bernanke appears to be fighting to save his job and reaching out to the people for understanding and support.

He told the audience that he had not wanted to prop up the big finance companies: indeed, “nothing made me more frustrated, more angry, than having to intervene” when corporates were “taking wild bets that had forced these companies close to bankruptcy”. Although “disgusted”, Bernanke was minded that “when an elephant falls down, all the grass gets crushed”.

This episode is interesting because it reflects a notable former economics professor confronting the possibility of a depression. It comes at a time when world trade and economic production is tracking the Great Depression. It would have appeared an impossibility even four years ago and economists are reeling, especially people like Paul Krugman are saying a macroeconomics education is “a costly waste of time”. He told an LSE audience that most macro was “spectacularly useless at best, and positively harmful at worst”.

Few Crystal balls

Economists did not see the crisis coming and are somewhat divided on how to treat it. When I studied economics at the LSE, it was widely assumed that crises were a thing of the past. Economic growth could be managed, and any small fluctuation in demand could be easily dealt with by adjustments in monetary and/or fiscal policy. We students thought it was not difficult to plan for growth. Paul Samuelson’s “economics”, our textbook dismissed crashes in a few lines.

But there was a stable environment. Banks were conservative institutions and very reluctant to extend credit. I recall an interview when I was a student, on a good scholarship, where I asked for a loan in order to buy a cheap Vespa scooter( these were much admired in the UK). I was given to understand that the risk was unacceptable. The manager implied that the mighty Midland Bank could come crashing down if I failed to meet my repayments, which I might do if I had an accident. I was in my mid-thirties when all that changed, and credit cards were showered upon me.

The main source of economic instability in my earlier life was foreign exchange. But there were strong management systems. In the UK and NZ foreign transactions were controlled. Tourists had limits on the amount they could spend. A property bubble was inconceivable as mortgages were tightly controlled. Practices were solid, and the theory appeared robust.

Keynes

Classical economists assumed that full employment was usual because supply created its own demand. They thought that income was either spent or saved. Spending stimulated the economy and savings went into investment

The theory did not explain the Great Depression. Keynes explained that uncertainty motivated entrepreneurs and savers alike to stay their hand. Both might develop a liquidity preference. Demand would fall. If private sector activity slowed, the public sector should be involved through low interest rates and public works if necessary.

The theory was avidly adapted in the western world. Keynsian economics worked to get the world out of depression, manage the war effort in the UK and USA without massive inflation, and promote growth though to the 1980’s. But economists were baffled by stag-inflation, and in the US split into two camps.

Freshwater v. Saltwater Schools

The University of Chicago blamed stagflation on central bankers who meddled too much in the economy in order to smooth oscillations. The lake-siders believed in the classical assumption that markets cleared, eventually goods were cleared leaving no inventory or unemployed workers. Their opponents were the coastal universities ( “salt-water school”) who held true to theory that markets could malfunction, justifying state intervention.

The Economist has recently reviewed this debate and said eventually the schools melded into brackish macroeconomics. One product was “inflation targeting’, embraced first by New Zealand, and later by Canada, the UK, Sweden and some emerging countries. Ben Bernanke was a renowned member of brackish economics. From the mid-1980’s until recently it seemed that macroeconomists knew what they were doing. Certainly there was price-stability and that was also the focus of central banks.

Blind spot

Economists and Central Bankers failed to appreciate the risk of financial instability. LSE professor William Buiter now argues that training in macro is a severe handicap. Student worried about the cost of goods and wage rates but did not think of the price of assets. Too much faith had been put in financial markets, and the financial system was under-studied.

In many macroeconomic models, it is assumed that insolvencies cannot occur. It stretches the bounds to credulity to discover that the Bank of England’s model is indifferent to whether business is funded by equity or credit. It does not even incorporate financial intermediaries such as banks. As Buiter observes, the model is useless for issues where financial intermediation is of importance. Pity this crisis is such an issue!

The modelers eventually smooth away many issues because they are too complicated. They find it easier to assume a firm can always borrow as much as it needs at the going rate or sell as much as it desires. This spilled over into financial organizations who made the fatal mistake that they could always sell structured products . but as readers of this column will know, that first casualty of the crisis was “over-the-counter” markets used for selling bundles of sub-prime or similar constructs. There was no exchange for these goods and sellers could not establish a market. Many firms disappeared in a liquidity spiral. It brought back Keynes’s concept of liquidity preference.

The Fed also had models which have not stood up well. In the summer of 2007 it predicted that even if the housing market turned down by 20%, GDP would fall only by 0.25% and there would be negligible unemployment. All the Fed had to do was reduce interest rates by 1%, and the damage would be contained! Fantasy in the Fed!

 

ECONOMICS IN CRISIS 2

NEVILLE BENNETT
AUG 09

On a visit to the London School of Economics in November 2008, H.M. The Queen demanded to know why nobody had anticipated the credit crunch. Predictably the School set up a committee, even co-opting the Bank of England and arch conspirator Goldman Sachs. With lightning speed it replied last week, a mere eight months later.

It blamed “financial wizards” who believed that their plans to protect the financial system were infallible. They were guilty of “.wishful thinking combined with hubris”. This is more charitable than the view put forward in this column recently (NBR 24 July) that the wizards are corrupt. The letter says, moreover, that the crisis was “caused principally by a failure in the collective imagination of many bright people…to understand the risks to the system as a whole”.

As explained last week, this is also the view of Ben Bernanke who is “disgusted” because corporates took “wild bets that forced these companies close to bankruptcy” ( NBR July 21). Nevertheless, at the same time I pointed out that the models used by the Bank of England were absurd in concentrating on price and labour cost movements but having no interest in credit.

Lack of imagination in economics

That brings the discourse focus back to economics, and more discussion of why economists in general have been found wanting. The Economist summed up the charge.. “they helped cause the crisis, that they failed to spot it, and they have no idea how to fix it.”. The charge is comprehensive, and untrue and unfair to all economics and economists, but it appears to have a hard core of substance in the case of macro and financial economics.

The critics have emphasized the flawed assumptions in models. Models assumed market efficiency: a firm could always get credit at the going rate and sell at the going rate. In the crunch the market for derivatives disappeared and many desperate firms could not get credit. Indeed, banks remain reluctant lenders, even to each other, and credit is tight in the US, UK and EU.

I explained last week that the Bank of England model did not include banks, and the Fed assumed away asset bubbles. Both banks focused on price not credit. The Fed also assumed asset booms would be smoothed by efficient markets, but even if they did not, it was more efficient to let them run their course and clean up afterwards. “Efficient markets” doctrine clashed with stopping a bubble forming.

Macroeconomists had imperceptible interests in financial markets. These enjoyed perfect information, competition, and always cleared. Their models assumed an asset would hold its price, even if everyone else was selling. They also though a few years data was enough: it established that house prices never fell and stock markets never lost more than 5%.

They had no interest in fiscal policy because it had few effects, it could be left to others such as political scientists. Paul Krugman says that of the 7000 papers published by the US National Bureau of Economic Research (1985-2000) only five mentioned fiscal policy in the abstract or title. The Bureau is the central clearing-house for macroeconomic research; it also dates recessions.

Nastiness in common rooms

Many economists are uninterested in the real economy, but they are capable of being perturbed when Paul Krugman dismisses their discipline as spectacularly useless and positively harmful. This could affect student numbers and cannot be ignored! Krugman compounds his insults by saying the masters should be re-read, especially Keynes in order to get back to a sound basis. Macro, he says is in a Dark Age having lost the wisdom of the ancients.

Krugman’s Keynesian call for massive spending is not universally supported in common rooms. One issue is the size of the multiplier. Keynesian’s often argue that a dollar spent by government on public works (now called “infrastructure”) resulted in more than a dollar’s worth of stimulus. Economic critics like Professors Lucas and Barro criticize the estimates of Barrack Obama’s economic advisors as absurd, according to the Economist.

Financial Economics

Financial economics is also struggling to restore its reputation. One core doctrine is the efficient market hypothesis (EMH): that the price of a financial asset reflects all available information. It is assumed that if the price was too high, smart investors would make money by shorting it. If it was too low, investors would go long. This was the basis of much hedge fund arbitrage. It was the basis too of many derivatives. The meltdown by Long-Term Capital Management in 1998 made no discernible impact on derivative writers who continued to under-value systemic risk.

Behavioral economists have been critical of financial economics for a long time. They insist that prices can get out of line for a long time, and emphasize that investors get too exuberant in booms and too much given to despair in slumps. But although the EMH is dented, it has yet to be replaced.

History Neglected

I personally feel that the lack of imagination admitted by LSE’s wise men owes a lot to the neglect of history, both of economic history and the history of economic ideas. Like Krugman, I have been re-reading classic writers and have found that crises have attracted much study in the past. I have read some great thinkers on a record of events, like Bagehot on the 1885 crisis and Lionel Robbins and J.K.Galbraith on the Great Depression.

There have been so many crises in the past that boom and slump is obviously inherent in capitalism. I have half-written a book making boom and slump the central part of a new interpretation of NZ history but lack the funds to complete it. I have no doubt there is a need for such history. (Gillian Tett’s “Fools Gold” helps explain the recent crisis)

While history can result in convincing explanation, there is also a need for a theory of crises and explanations of their everlasting occurrence. At another time, I hope to show that ideas from Sismondi (died 1842) Aftalion, Speithoff, Cassel and Schumpeter have relevant insights.

Fed/Bernanke… Congressional Oversight… Monetary Policy… Deficits… UK… China… and More

Chris Gaffney…

The markets were watching Ben Bernanke’s congressional testimony through most of the day, but those waiting for a surprise were disappointed. Bernanke stuck to the script which he had laid out the day before in the Wall Street Journal, and the members of the House Financial Services Committee couldn’t get him to commit to any ‘new’ stimulus programs. Bernanke said the economy is showing “tentative signs of stabilization” but the central bank intends to continue to maintain its “highly accommodative” monetary policy for “an extended period”. He indicated that the Fed stands ready to tighten policy, but only after the economic recovery takes hold and pressures holding down inflation diminish.

The Fed Chairman also reiterated his desire to keep the Fed independent from additional congressional oversight. As Chuck reported a while back, 275 legislators sponsored a bill to repeal the immunity of the central bank from audits of monetary policy. Bernanke said the bill would “open a Pandora’s box” for Congress’s Government Accountability Office to probe monetary policy. While I don’t necessarily think the folks in Congress are any more adept at handling the financial crisis (more on that later), I am a fan of opening up the books and letting the ‘owners of the government’, (the taxpayers) see just what all of their taxes are being spent on. Again, I’m not advocating that the Fed should seek congressional approval for every move they make, but I do think an after the fact audit is a good thing. I just get the feeling Bernanke and his pals are trying to hide something.

When pushed about this bill to audit the Fed, Bernanke pushed back at Congress and told them they need to cut the ‘unsustainable’ budget deficits. The Senate took a somewhat symbolic step toward this yesterday, by killing the F22 Raptor fighter jet program. If you hadn’t been following this, it is an excellent example of how spending can spiral out of control. Back in April, Defense Secretary Robert Gates decided, with President Obama’s backing, to scrap the program once it had delivered the 187 F-22s already in production. F-22 supporters in Congress ignored what the military wanted, and went ahead and budgeted another 2 billion dollars to continue production. I know 2 billion is next to nothing with the trillions that we have been talking about, but every little bit counts. If the US Government is going to get spending under control, they have to start somewhere; and killing a program that creates a plane that the military says they don’t need, and don’t want is a good first step.

Budget deficits aren’t the exclusive problem of the US. The Pound Sterling has been coming under some selling pressure lately as the UK budget deficit swelled to a record $21.4 billion in June. This was the largest monthly budget deficit ever recorded, and is increasing pressure on Prime Minister Gordon Brown to commit to a credible plan to cut spending. Recent data coming out of the UK doesn’t paint a pretty picture of the economy. Yesterday data showed that UK house price declines will persist until 2012, and another report predicted gross domestic product will keep falling until the final quarter of this year. BOE policy makers voted unanimously to maintain their asset purchase program in July, another sign that they still feel the UK economy is on shaky ground.

While the BOE and the Fed continue to use their reserves to purchase their own debt, China announced it would be looking to use its huge stash of cash to make purchase assets which have a bit more intrinsic value. A story in the FT yesterday stated that Beijing will use its foreign exchange reserves, the largest in the world, to support and accelerate overseas expansion and acquisitions by Chinese companies, according to Wen Jiabao, the country’s premier.

In an interview published in state-controlled media, the chairman of China Development Bank said Chinese outbound investment would accelerate but should focus on resource-rich developing economies. “Everyone is saying we should go to the western markets to scoop up [underpriced assets],” said Chen Yuan. “I think we should not go to America’s Wall Street, but should look more to places with natural and energy resources.”

This is a shot across the bow for the US, and a huge boost to countries which are commodity rich, including Australia, Brazil, and Africa. This is further evidence that China is looking to slow its purchases of US treasuries, and reduce its reliance on the US dollar as its reserve currency. Investments will focus not on monetary instruments, but on physical assets in resource rich developing economies.

Government Debt – Analysis of Developed & Emerging Countries

Government Debt

Neville Bennett

This “Greater Depression” is a profound turning point in history. Recently, I analyzed how it had tipped the balance in global GDP away from the West to the emerging world (NBR June19). That change arises partly from differential economic growth rates. Obviously more is involved, and my focus now is on public debt and demography.

In essence, ever since the Asian Crisis, emerging countries have cleaned up their balance sheets and now have significant savings. But the developed world is encumbered with an ageing population, and unsustainable commitments in health and pensions. These prevent the paying down of public debt, which has been overblown by the need to bailout banks and fund costly stimulus packages. Japan and the UK are illustrative cases, but there may be lessons for New Zealand in this issue, as credit ratings come under pressure.

Global Public Debt

Governments have possibly stabilized the financial sector but there must be doubt about the remedy: massive public debt. According to the IMF, by next year, the gross public debt of the 10 richest countries will have risen from 78% of GDP in 2007, to 106%. It is an increase of $9 trillion in three years. New Zealand has made a modest contribution to this. Its public debt in May 2007 was NZ$28.8 bn, rising by a quarter to NZ$36.6 bn in May 2009.

There is worse to come. Weak economic growth and revenue, plus increased expenditure point to large budget deficits. The IMF believes public debt will be 111% of this groups GDP in 2014, but in a worst case scenario it may reach 150%. (See chart.)

This is the highest peacetime borrowing on record. The world economy will struggle for a decade at least with the weight of this albatross around its neck. It is the result of the paradox that crash caused by too much debt has been remedied by government bailouts to keep economies completely falling off the cliff. Most economists agree with this pump-priming in principle, but they may thereafter disagree on some aspects (for example: too much to banks) and the timing the necessary return to sounder fiscal management.

To be sure, governments have been ably to service this debt quite cheaply. Their reserve banks have driven down rates in order to stimulate the economy, and markets rates have been low as investors have flocked to find safety in government-backed securities. Nevertheless, yields are rising in response to new issuances and the cost of debt servicing is increasing net debt appreciably.

Will governments try to pay off the debt at the cost of lower economic growth? Or will try to inflate the debt away? Inflation can reduce the real cost of debt, and is attractive to governments as it is more politically acceptable than tax increases. But the cost is much higher than many politicians think.

The cost of high inflation is horrendous. Investors will buy debt only if they can make a real return. This requires an interest rate well above the CPI. If inflation is running at 10% p.a., medium term interest rates have to be higher, say 12%-16%. In the process, unless a lot of debt is paid off, the remainder will grow in line with interest rates. It is like a dog chasing its tail. The debt reduces when the dog is exhausted and can chew its tail. Meanwhile, high interest rates have slayed the economy. Only hyper-inflation destroys debt but it also destroys the middle class.

Recent History

Public debt always rises after recessions because Keynes’s policy of pump-priming is universally accepted. Some countries default. But the richer countries rely on fast growth. More recently some very fiscally responsible states like Canada, Sweden, Ireland and New Zealand have restrained public debt.

Although New Zealand will triple its bond issuance from about NZ$5 bn p.a. in 2008-9, to NZ$ 15 bn. in 2013-15,

It will keep public debt at a reasonable proportion of GDP. It is forecasting gross public debt as a proportion of GDP at 41.1% this year, rising the 45% in 2012-13 and 49% in 2014-15.

This is clearly responsible, but it does rest on projections on increases in GDP which may be optimistic. I am apprehensive that interest rates may rise to attract foreign investors, and that will be a drag on economic growth. Moreover, if NZ yields are attractive, the NZ dollar is likely to soar above fair value, hurting exports and our important tourist and student markets.

Rebound?

A rebound is difficult. Exports may be sluggish, particularly as households are rebuilding their balance sheets, with a marked reluctance to buy big-ticket items. The richer countries may follow a version of Japan’s past, where it is very difficult to stimulate the domestic economy when asset prices are falling. The Japanese Government has pump-primed until it is gasping. The country is still in deflation, but its gross debt-ratio has tripled from 65% of GDP in 1990 to 170% now.

Other Fiscal costs

The problem of repaying the cost of the bailout is dwarfed by the cost of an ageing population. According to the IMF, the present cost of the bailouts is only one tenth of the financial cost of ageing. If this problem is not addressed, demographic pressures will send the debt of the big rich economies to around 200% of GDP by 2030.

The world has regarded emerging country debt as the most in risk of default. This is an anachronism. The emerging members of G20 had a debt-GDP ratio of 38% in 2007 and it is falling to perhaps 35% this year.

The rich countries need to be careful to avoid tightening policy too soon for fear of snuffing out economic growth. But they may need to take other action to free up fiscal elbow-room. Pensions are an obvious problem, and raising the retirement age seems imperative as many superannuation schemes are unfunded. S&P have made it clear that the UK either raises taxes or cuts pensions and health spending if it is to avoid a credit downgrade. This is problematic as funding civil service pensions alone can amount to 85% of GDP.