The Weekly Report
Dangerous Times - Be careful what you read when Antole Kaletsky is writing
Welcome to the Weekly Report. I have been reading the mainstream media of late to get a feel for the level of understanding writers (and therefore the vast majority of their readers) have for the new economic situation that faces the global economy.
I have to report that the situation is not good, many writers are behind the drag curve, talk only of the present and fail to understand what the US and UK Governments and Central banks are trying to achieve. Most writers believe the UK is going to follow the US in its policies and actions. I have disturbing evidence that such assumptions may well be mis-placed, evidence that shall present later in this article.
Most of my subscribers and those that read the "free" content (it's not really free to produce, it takes time and resources to write and the free content is used as a form of advertising) probably do not read as much of the mainstream financial media as do those others who have not discovered the financial blogging and website part of the internet. I was "created" via the internet and continue to occupy a small part of the web, my readership comes from such an environment where not only do they read my macro-economic thoughts but also those of other bloggers and writers who follow a similar existence as I do. We are ignored by a huge part of the public, not because we are irrelevant but because they do not know we exist. So this weeks article is aimed at those who rely on the mainstream financial media or government spokespersons for their information.
It would surprise the global public if they knew just how long I and others had been predicting, with evidence, that not only would there be a credit crash but that the global governmental response would follow what we see today. Many of us throw our collective eyes to the ceiling when we read the uttering's of the mainstream media and politicians, saying that the "crisis could not have been foreseen". It was foreseen by more than a few individuals but we were ignored, treated as a small freak show because we disagreed with those saying the goldilocks era would last forever. To give you some idea of the timescales involved I have been laying out the steps that would lead to our current position for over 5 years, other writers/bloggers have been warning for even longer.
It is not in the interest of the Investment Banks (RIP), Stockbrokers, Banks, Hedge funds, Governments etc to allow warnings about the consequences of the expansion of various bubbles to become widespread public knowledge. With such knowledge the public would drastically change the way it invests, saves and spends. It would go against the requirement that a fiat (banknotes backed by confidence) monetary regime requires constant expansion of money supply (at around 2% to be optimal) to allow a credit driven expansion of an economy. Money supply is expanded, given to Banks who lend it out or use it to leverage (create) larger pools of money to be lent out, in the form of credit, to those who think they can gain a return on this borrowed money that will be greater than the cost of borrowing it. Many businesses (and eventually the public too) became reliant on rolling credit, expanding the amount borrowed to repay old debt and use the extra debt to fund purchases for expansion. With a 2% expansion guaranteed by the increase in money, the increase in prices charged would expand the profit (be it gains in house prices or higher prices for services and goods) and allow for an increase in higher levels of borrowing.
However when that ability to increase the amount of credit is curtailed, when Banks decide that it is too risky or their own precarious balance sheets need repairing, the game of rolling old debt for new is over.
We are living this right now; you and I are going to be part of history, a period of time that will be labelled, akin to the '30's and the Great Depression. I don't want to scare or depress you but readers must realise that the current financial climate is unlike anything any currently living person has seen.
So back to this weeks topic of how the mainstream media are forming the discussion about the financial crisis. Nearly all economists and financial writers look at the problems of today from a Keynesian or Monetarist viewpoint. If you are unsure of what these schools of thought are click on the links. These methods are being used to shape your life, it is in your interests to understand what the thinking is behind the Government current actions.
I have decided to look at Anatole Kaletsky, who writes for the Times newspaper in the UK. Last week he published an article entitled "Punish savers and make them spend money" which I urge you to read as it will be central to the counter points and explanations I intend to lay before you. Let me state that I do not intend to "de-construct" Mr Kaletsky, rather I want to show that those writing from a conventional economic stance, taught in Universities and based on Keynes are at a major disadvantage and struggle to understand the dichotomy presented to them. We should also keep in mind that Central Bankers and politicians invariably come from the same school of thought, regardless of their political beliefs.
In Mr Kaletsky's article he begins with:
"The question, of course, is what to do about the recession. Specifically whether the way out is "to spend, spend, spend or to save, save, save" - as David Cameron has so clearly put it.
I believe, in line with the vast majority of non-socialist economists, that Mr Cameron's campaign for savings is completely wrong; that "borrowing our way out of debt", paradoxical as it sounds, is exactly the right prescription for our present problems"
He believes that if new debtors replace those that are no longer capable of borrowing then the financial system will be stabilised. However he then dismisses what he believes would work (although he doesn't recognise that indeed the idea is fatally flawed, whom do the new debtors borrow from?) as he makes a statement that is central to what is to come for us all:
- "But what I think is of little importance.......Only two opinions matter: on one side, that of the Obama Administration and the Brown Government; on the other, US and British consumers."
In this regard he is absolutely correct. The argument about what to do, whether it is saving (in my opinion the correct thing for individuals to do, along with paying off debt) or increasing debt to engender a recovery in spending is now moot. The actions taken by the US show that the discussion has been and gone, they have decided to follow a Monetarist approach that is deeply theoretical and is NOT a copy of the Japanese deflationary experience.
Japan used a Zero Interest Rate Policy (ZIRP) combined with Quantitative Easing (QE) to attempt to reflate their economy. To some extent it worked but it left a fragile financial framework in place that has weakened considerably in the current crisis. Follow the links to read about both of these phenomena, again you need to know if you wish to make the right choices and understand what will happen in the future.
Ben Bernanke, the Chairman of the Federal Reserve has studied both the '30's and the Japanese deflationary periods in depth. Fortunately he published papers and books on the subject along with other like minded economists, including GB Eggertsson. Eggertsson looked at the Keynesian and Monetarist approach to deflation and attempted to show that the Monetarists are right when they say monetary and fiscal policy can be combined to engender credible future inflationary expectations in the minds of the public and business owners. It was these expectations that the Japanese failed to ignite, thus the public and business continued to act as though the appreciation of money and falling prices would continue. This caused spending to be delayed as buyers waited for even lower prices in the future.
Eggertsson believes inflationary expectations could be achieved by ensuring that the increase in money would be combined with a policy that kept interest rates across the whole spectrum of government bonds, not just Central Bank base rates, at an artificially low level which in normal economic conditions would be an extremely inflationary policy to follow. Couple this with fiscal stimulus, such as tax rebates and increasing public (and therefore Government) debt to spend on large scale infrastructure or other "back to work" schemes it is hoped that this would encourage investment and spending to happen in the present to avoid higher costs in the future. The irresponsible but credible inflationary path taken by the Government would raise future inflation expectations because it would be expected that the Government would eventually monetize the increased debt.
This is a huge and untested application of a theory in Monetary Policy that is already struggling to have an effect. What the theory hasn't allowed for is the real term impact of a reduction in productivity, investment and expansion that has led to a crisis of confidence. The public see massive and rapid increases in unemployment and housing foreclosures and rapid and powerful decreases in the returns on investments and savings and the loss of the ability to borrow. Business sees an environment where investment is impossible due to the restriction of credit, falling revenues and the destruction of profits. A cash rich company will not risk using its own cash to invest in such an environment, the returns from holding cash are greater than the risks of using cash to invest.
As this crisis of confidence takes an ever firmer grip on the public's economic outlook they no longer worry about whether policies are inflationary or not. They worry about the survival of the system and more importantly their place in that system.
As you can see Mr Kaletsky is correct in his assumption that the fight about ideals is now firmly entrenched between the US Government and the US public. The US government has acknowledged this will be a long term recovery process that will probably begin at a lower economic base than we presently see, the bottom for the US is not yet "in". The US will increase and make permanent tax rebates, Government spending schemes, ZIRP and QE until inflation returns and holds steady. That could be some years into the future and it will only occur if the mind of the public is turned from fear of deflation and its effects to a fear of inflation. There is no guarantee that the last requirement is going to happen and without it the US faces a Japanese scenario of long term (15 years) deflation and a weak recession prone economy even after that period has elapsed.
It should be remembered that deflation is not necessarily bad for growth and in times before the Second World War it was not unusual for economies to swing between inflation and deflation. Only after the creation of the Federal Reserve in the 1900's do we see the gradual elimination of deflationary periods in the US:
No one can deny the massive expansion of the US economy from its beginnings to the 1900's which occurred with deflationary periods throughout its history. So what makes the current situation so much worse?
The use of leverage to create massive positions increased the destructiveness of losses when those positions went "bad". This coupled with enormous amounts of debt (made possible by Banks selling debt packages to other Institutions and thus freeing up the capital to repeat the procedure) caused capital to be used up at a frighteningly quick rate to cover losses. Soon Banks et al had gone below their capital reserve holdings and had to look to others and eventually the Federal Reserve for more capital to shore up those losing positions. These positions are not covered, just the amount required to allow the leveraging has been replaced. That's because losses are not deducted from the borrowed cash, the loss is borne by the money or assets put up to secure the loan. If those losses exceed the amount of collateral put up, it has to be replaced.
Therefore if the collateral is equal to 10% of the amount borrowed, a 10% loss on the whole position wipes out the collateral. To keep the position open you need to replenish the collateral or you have to close the position, return the borrowings and take the loss. This loss of capital is why banks have stopped lending across the board, even to credit worthy individuals and businesses. They need to hoard capital and revenues to prepare for any future losses. The Banks are not acting as if they have expectations of future inflation.
Until this changes participants in the economy, reliant on credit to continue, (let alone expand) will be under severe strain. To survive they will cut spending, costs and investment. The ability of money, regardless of the amount it is increased by, will not be able to cause an expansionary wave as it will become an asset in its own right, hoarded and saved by all. When assets are in demand and the return is greater (deflation makes money worth more, it has a higher purchasing power) than other "non-money"assets there is no requirement to spend. Why swap the highly priced asset for one of lower value?
Without the need to invest or to expand in the search for higher returns to beat inflation the current financial system cannot function because it is based on leveraged credit. Remove the need for credit and the use of leverage becomes redundant. This has a natural effect on prices, they fall. If business previously carried out was driven by a use of 90% of borrowed money, the removal of that 90% means business is restricted to the 10% left, the original collateral. Prices of assets will have to fall to meet the shortfall of cash. The other alternative is for the asset suppliers to remove themselves from the market place, making the assets unavailable until the price they want is met.
All of the above, from the quote from Mr Kaletsky's article to the paragraph you last read was to explain what his quote referred to. The US Government will do everything it can to engender a credible expectation of future inflation amongst the public and business. As you can see the forces the US Government has to overcome to make this happen are formidable.
This is why Mr Kaletsky then made the following remarks in his article:
- "The next logical step, although it may be politically controversial, would be to do the opposite of what the Tories suggest. Instead of reducing taxes on interest payments, the Government could tax all bank deposits and other risk-free savings. This would create a negative risk-free interest rate, encouraging savers either to invest in property, shares and other productive assets - or simply to save less and consume more. In either case, the result would be more consumption and physical investment, less unemployment and faster recovery from the slump."
In other words such taxation would be viewed as a form of inflation acting on savings. It would actually cost savers to hold cash, negating any increase in the worth of the currency the savings are held in during a deflationary period. This would force savers to spend their savings on assets in a search for a return.
However, this thinking is flawed as it would be counter productive to the domestic economy.
Savings do not have to be held in an account, cash is available in large denominations and can be held in secure vaults. Cash can also be transferred to another tax regime that is friendlier; it would also allow some countries to attract capital. In Japan the outflow of savings caused the carry trade as domestic savers sought higher returns elsewhere in the global economy. The increase in the supply of Yen without the expectations of inflation allowed Japanese savers to become foreign investors in the US, UK, Europe and the emerging markets. Finally Banks need deposits, savings, to allow fractional lending. Without a deposit base Banks do not have the collateral, the reserves, to allow lending. Any government bailout money would only replace the lost deposits, it would not increase the lending power of Banks.
Therefore the next logical step would involve higher income surveillance by Government to see if cash was being hoarded outside of the banking structure. The outflow of cash to foreign investments can be expediently stopped by the adoption of capital transfer restrictions and the control of foreign cash holdings. That would ignite a protectionist economic war that would destroy globalisation.
At the end of his article Mr Kaletsky puts forward the notion that even Mr Obama would balk at implementing a savings tax and that the current ZIRP and QE policies would probably boost consumption and investment. However, as I have shown above even the US Government and especially the Federal Reserve do not believe such policies will work unless the expectations of the public and business are changed. Mr Kaletsky has caused quite a stir amongst his readers with his tax on savings idea, unfortunately he is missing the point and has not thought about the future effects of such a policy. His "non-socialist" approach would be undone if such a policy was implemented, the very actions of the savers would force heavier centralist government control of the individual.
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