#58. Storm Front – part 3

WHY RESPONSES TO THE LAST CRISIS WON’T WORK NEXT TIME

In the first part of this series, I explained why I regard China as a financial disaster waiting to happen. In the second, I looked at what the broader consequences might be. Here, I turn to what should be done when the next financial crisis explodes.

That a new financial crisis will explode increasingly seems probable. The world’s solution to a massive debt problem has been to borrow even more, and the numbers make it painfully clear that this isn’t going to work. Looking around the world, the “storm cones” seem to be being hoisted in an increasing number of places.

The key conclusion here is that repeating the policy responses of 2008 will not be possible and, more to the point, would not be desirable anyway.

Interest rates that are already at zero cannot be cut further and, in any case, ultra-low rates, engineered using QE, have helped to make a new crisis virtually unavoidable.

Governments are now far more indebted than they were in 2008, so bailing out the banking system, even if it is possible at all, will have to be done very differently. It will not be feasible this time to duck costs that were evaded in 2008. Any further tinkering with the fiat monetary system would run a high risk of destroying it altogether.

What, in my opinion, has to happen this time is an acceptance of the challenge rather than a strategy of “extend and pretend”. Where bank support are concerned, it will not be possible for governments to take over banks as if they were going concerns, preserving their structures and compensating shareholders at something approximating to market value. This time, governments will need to preserve the ‘utility’ elements of banks and backstop depositors.

If, as seems likely, property prices are one of the bubbles that burst, a possible counter to negative equity may be to offer voluntary conversion from (negative value) ownership to rental status. The banks would avoid massive write-offs, homeowners would be freed from negative equity, nobody need be rendered homeless, and the market would not be deluged by forced sales. Big write-offs could thus be limited to mortgages on buy-to-let and second homes.

Above all, we are in clear need of responses planned in advance, which was not the case seven years ago. This time, when there is even less excuse for a lack of preparedness, policymakers and central banks need to find something better than “extend and pretend”.

The charts below provide a snapshot explanation of why a new crisis looks very likely. In the period between 2000 and 2007, global debt increased by $55 trillion, or $38 trillion if we consider “real economy” debt, rather than inter-bank borrowing. Since 2007, debt has grown by $57 trillion, of which real economy borrowing accounts for $49 trillion.

China etc July 2015

Having taken on $2.18 of real economy debt for each dollar of growth in the earlier period, we have since increased this to almost $3.

This is insane.

And even this metric understates the real scale of the problem, because most of the “growth” is actually nothing more than the spending of borrowed money, and will, therefore, reverse, if we are ever forced to stop borrowing.

In a nutshell, then, a financial system that found itself in a hole has carried on digging.

What went wrong last time

Seven years having elapsed since the banking crisis, we are now have a perspective from which to summarise how the world responded.

Two things are clear.

First, the responses to the 2008 crisis haven’t worked.

Second, we could not now repeat those responses, even if we were foolish enough to try.

The basic problem in 2008 was one of too much debt. More specifically, it was too much of the wrong type of debt.

Not all borrowing is bad. Essentially, “good” debt is self-liquidating. If the owner of a successful restaurant borrows to add extra tables, the increased income will pay off the debt. Borrowing to increase your skills should boost your future earnings, enabling you to pay off the debt. Mortgage debt, prudently managed, has made home ownership possible for millions.

Unfortunately, in the years before 2008, the financial system proved increasingly ingenious at pushing the wrong kind of debt. There are many bad forms of debt. A bad debt may be one that the borrower simply cannot afford to repay or, worse still, cannot even afford to service. Borrowing for consumption rather than for investment is generally a bad idea. Borrowing for speculation isn’t a great idea either. Separating risk from return tends to be disastrous, as does borrowing to inflate asset values.

All and more of these forms of bad lending proliferated in the run-up to the crisis. Thanks to the disastrous repeal of the Glass-Steagall Act at the end of 1999, and of its equivalents elsewhere, banks were now allowed to own securities operations which, increasingly, became debt-pushers as banks created “profits” by destroying their own balance sheets.
Sub-prime mortgages, bad enough in themselves, became worse when primed to self-destruct (as Adjustable Rate Mortgages or ARMs), and worse still when packaged into securities which, ludicrously, were accorded investment-grade ratings. These securities were a disaster, first because investors didn’t really know what they were buying, and second because they enabled the separation of risk and return.

More generally, property markets were inflated by the influx of easily-available lending, much of it made possible because previous rules on loan-to-value (LTV) and loan-to-earnings ratios were relaxed.

There is something that we – unlike, it seems, bankers and politicians – need to understand about mortgage lending. Say that Mr X can afford mortgage payments of $5,000 per year. On an interest-only basis (to keep it simple), this means that he can afford to borrow $100,000 if the interest rate is 5%. Lower the rate to 2%, however, and he can now borrow $250,000.

Unfortunately, just as Mr X can now afford to borrow much more, so can everyone else. So, instead of buying a better house, he can really only buy the same house for more money. So property prices at any given time are a function, not of supply and demand, but of the amount, cost and ease-of-access of mortgage funds.

This mountain of debt, dangerous in character as well as in sheer size, began to wobble in 2007 – when bankers began to find it difficult to know which other banks they could trust – and fell over completely in 2008. As the wholesale debt markets seized up, bad debts were crystallised and the banking system teetered on the brink of a black hole.

What we did wrong

If circumstances change for the worse, borrowers can easily become engulfed by too much debt. The fact that they cannot repay it is the second problem, not the first. The really pressing issue is keeping up the payments. Having more debt than you can repay is insolvency, but being unable to meet interest payments is illiquidity, and that can be far worse.

This presented policymakers and central bankers with three immediate problems.

First, a vast swathe of banks were insolvent and, far worse, faced becoming illiquid.

Second, borrowers were unable to keep up interest payments, something which, if it happens on a big enough scale, creates bad debt write-offs that can easily destroy banks’ entire loss-absorbing capital (which was, and remains, far too small anyway).

Third, economies pumped up by activities such as real estate and finance could suffer severe setbacks, making the debt-servicing problem even worse.

Governments and central banks acted, first, to prevent panic, partly by guaranteeing deposits but principally by intervening, either taking banks into public ownership or foisting them off onto solvent but gullible competitors. In Britain, for example, the state had no real choice but to take over Northern Rock and the Royal Bank of Scotland, both of which had followed very risky business models. Shareholders were compensated at something approximating to the share price, and structures were kept intact, meaning that most senior executives, though chastened, kept both their jobs and their assets.

Simultaneously, central banks cut their policy interest rates virtually to zero. There was some Keynesian calculation here – lower rates act as a stimulus – but the main aim was to prevent borrowers from going bust. Fiscal policy loosened dramatically, less as a deliberate act of strategy than as a simple consequence of tax income crashing and welfare costs rising.

Central bankers soon realised, however, that cutting policy rates wasn’t going to be enough, because interest rates are really determined by bond markets. If these fall, rates (which are the yields on bonds) rise. Conversely, if bond markets can be pushed higher, market interest rates will fall. For this reason, central banks resorted to QE (quantitative easing) on a huge scale, inflating bond markets (and thus manipulating yields downwards) by buying bonds using money newly created for the purpose.

Unfortunately, none of these measures was a permanent fix. Government debt ratios increased dramatically, as did fiscal deficits. The banks – and the bankers – were bailed out with cheap funds, which for the most part they were encouraged to lend. In most countries, really severe falls in property prices were prevented. Mortgage payments fell sharply, bailing out the reckless at the expense of savers.

It should be no surprise at all that of this restored, not just a semblance of “business as usual”, but ‘recklessness-as-usual’ too. Bond markets soared – an intentional policy outcome – and ultra-low costs prompted a renewed surge in borrowing.

Seven years on, very little has changed. Property and other asset markets are even more inflated than they were in 2008. Government debt ratios have soared, and getting annual borrowing back down has proved a long slog. Economic recovery has been lacklustre, and even such growth as has been achieved is mostly phoney, amounting to nothing more than the spending of borrowed money.

Western economies remain on a treadmill of borrowing to grow – in Britain, for example, official projections indicate that the economy will grow by a nominal £500bn over the coming five years, but only if households go on a £330bn credit binge as well as borrowing a further £500bn in order to inflate house prices by another 35%.

Just as the Western economies have reverted to type, the hope that emerging economies might become the new drivers of the global economy have proved false. Three of the four much-vaunted “BRICs” – China, Brazil and Russia – are crumbling as we watch. India aside, these countries are vindicating the minority who, all along, suspected that the fashionable enthusiasm for the BRICs might not stack up.

What could we have done instead?

Alternative history can be an absorbing read. There are very interesting books which postulate, for example, a successful German invasion of Britain in 1940 (Kenneth Macksey’s Invasion: The Alternate History of the German Invasion of England, July 1940) or the failure of D-Day (Disaster at D-Day by Peter Tsouras).

In the same vein, what might an alternative response to the banking crisis have looked like? We need to know, because repeating the 2008 policy responses will not be an option when the next crisis happens.

In its early stages, the next crash is likely look a lot like the last one. It seems likeliest to start in China, where soaring debt has been invested in surplus capacity which has in turn driven profits sharply downward.

As with American sub-prime in 2007, the first impact will be the dawning realisation that many borrowers will be unable to keep on servicing their debts. This will lead to a seizing-up of credit markets, because participants cannot be sure which counter-parties are solvent and which are not. This will bankrupt institutions which have based their business model on recycling wholesale debt.

At the same time, the scale of exposure to bad debt – most notably in China – will gradually become clear. The backdrop will be a recognition that the economy is poised to turn down, making debt even harder to service.

In 2007, governments made clear their willingness to stand behind crippled banks, not just by guaranteeing deposits but also, where necessary, by taking banks into state ownership. But this will be far more difficult this time, mainly because governments are far more indebted this time around.

In 2007, the net-debt-to-GDP ratios of, for example, the United States, Britain, France and Japan were 44%, 38%, 57% and 80% respectively. Today they are 81%, 83%, 88% and 137%. Globally, the average government debt ratio is 83% today, compared with 63% in 2007.

This puts the rescue of banks into a wholly different context. In 2008, governments essentially reimbursed bank shareholders at something approximating to share prices, but the reality was that, in the absence of government support, these banks were worthless. It might have been better had governments recognised this, giving shareholders little or no compensation.

At the same time, banks were taken over as going concerns, which in most cases was exactly what they were not.

A better approach can be exemplified by looking at the British government’s rescue of RBS. Instead of taking over the existing corporate entity, the state could instead have set up a new company – say “RBS 2” – which could have shouldered the RBS assets and liabilities on a selective basis. The liabilities not taken on would have included the employment contracts and accrued pensions of senior executives, whose former employer would have ceased to exist.

The banks’ investment banking divisions could have been split out, and perhaps handed to the shareholders, being allowed to sink or swim at no further cost to the taxpayer. The longer-term aim would have been to turn the acquired banks into wholly retail operations, to be returned to private ownership when and if conditions allow.

More generally, the denial of government support would have resulted in widespread bank failures. With hindsight, allowing banks to fail – whilst protecting depositors – might have been a better response than propping up insolvent banks. Customer deposits and the branch network could have been taken into state ownership, to be returned to the private sector in due course in a far more sober form.

Monetary policy was, and remains, the really critical issue. As things stood, a failure to cut both policy and market interest rates would have resulted in extremely sharp falls in house prices, creating vast swathes of negative equity and seizing up property markets because millions of buyers, saddled with negative equity, would have been unable to sell.

Again, it might have been better to take this hit and let property prices slump, rather than distorting the entire monetary system (and penalizing savers). A bad debt – technically, a “non-performing” loan – is created when a borrower can no longer service the debt. Even if he can service it, however, a second problem exists where a property, bought using a $100,000 mortgage, becomes worth only $80,000.

Here, an alternative would be for ownership of the property – “ownership” which is purely notional, having no net value anywayto be transferred to the lender, with mortgage interest payments converted into rent at a level that the customer can afford. The borrower is freed from negative equity, the market is not deluged with forced sales of properties, no one becomes homeless, the bank avoids write-downs (because debt is converted into equity) and property markets are reset at far lower levels.

What needs to be borne in mind here is that high property prices are bad for an economy, not good. Purely notional equity emboldens homeowners to taken on excessive credit, vast amounts of investment (which could otherwise be put to constructive use) are tied up in a useless capital sink, value is transferred between generations, and young people are put at a huge disadvantage.

What do we do now?

In short, an alternative response in 2008 would have been to let both banks and asset (including property) markets collapse. The state could have guaranteed customer deposits, and salvaged the banks’ purely utilitarian operations. The negative equity imposed on millions could have been erased by offering the option of converting from mortgage to rent.

It is hard to see how this could have cost more than what actually happened. The plus-side would have been that markets could reset without a resort to subverting the monetary system, penalizing savers and setting the scene for a renewed surge in borrowing.

When the next crash comes, governments will be forced to consider responses along these lines. Their existing debt levels will preclude taxpayer interventions on the 2008 model, and interest rates already at virtually zero cannot be cut further, whilst any further resort to QE could destroy faith in the monetary system.

It must be hoped that there is some preparedness, at least, for countering a very similar crisis in a very different way.

36 thoughts on “#58. Storm Front – part 3

  1. Thanks for this Tim – very thought provoking. Do you think that the much vaunted bank “stress tests” are worth nothing or is is just a matter of the degree of severity of a crisis as to how much comes tumbling down?

    • Thank you David.

      I think the stress tests are of limited value. From recollection, the UK ones (probably fairly typical) assumed a fall in GDP of less than 2%. That’s not a real test, in my view – least of all for a country with a 5.9% current account deficit and a big (though shrinking) banking sector.

      The authorities are torn here. Be too soft and they fail to reduce risk enough, and may lack credibility. Be too tough and they would cramp lending, which the economy nowadays depends on. I think the need for consensus pushed them towards the softer end.

  2. Hi Dr Morgan

    I agree with your analysis but tend to disagree with its conclusions, or at least some of them.

    You recognise the emblematic nature of house prices and I think that TPTB will be extremely reluctant to embrace your solution, not because it is not economically sound, but because it is politically extremely difficult. It wouldn’t surprise me one bit if TPTB didn’t try one more time the bank and house price bail out option that was implemented before, however foolish it is from the economic point of view.

    Let’s face it in the UK at least a recession that may not be subject to countercyclical policy (because of ZIRP et al) together will a fall in house prices and a conversion to renter status (the ultimate humiliation) spells suicide for the party in power.

    I think, as you do by implication, that Yellen, Carney and all the political masters have brought us to disaster but that doesn’t mean they will go rationally or willingly into the night.

    • Thank you, Bob – and do always feel free to disagree. I relish debate.

      On house prices, I agree that they may well try. But I think they will fail. Remember that we’re talking a big economic hit here – which by the way we are already seeing, with real Chinese growth probably down to 3%, vehicle sales and factory output both down about 6% y-o-y, commodity prices really cratering, and freight rates apparently below 1998 (!) levels.

      I expect huge banking losses which, even if the system recovers, would crimp new loan issuance – without which, housing markets (where there are always some sellers) would go into reverse. Incomes are bound to take a hit, too – and we might (I stress “might”) see market (not policy) interest rates pushed up by scarcity, unless CBs think they can risk more QE. Market sentiment can have a huge impact, too, if many rush for the exits. As I say, though, do tell me if you think I’m missing something.

      My post doesn’t address popular responses, but I don’t think rescuing bankers and helping the wealthy (a by-product of QE) will be tolerated as much this time.

      I agree, too, that governing parties will attempt to preserve the status quo. In 2008, they succeeded – just – though the UK banking system came within 15 hours of failure. But I’m not so sure they can succeed. I see the UK as socially as well as financially vulnerable, but would have to ask what the choice is? Jeremy Corbyn? Or one the three Blair-lookalikes? (If there were a “transfer market” in politicians, there’d be huge US bids for DC and GO, given the extreme paucity of presidential candidates over there).

      The UK housing market has become totemic, but that just makes the problem worse.

      My theme here is not that we’ll want to take the hit this time – we never do – but that there might this time be no choice about it.

      If you can tell us what they might do instead of what I’ve outlined here, please do.

    • Surely, the one other thing that they can (and will do) is resort to the last refuge of central banking scoundrels, retail price inflation? The policy makers already need to respond to China’s attempt to export deflation worldwide, and short of currency controls and duties, inflation helps devalue western currencies against the reminbi.

      Domestically, by constraining interest whilst expanding the money supply, it amounts to paying off debt by stealing from the holders of cash denominated assets. That’s not an unusual outcome in historic terms (and not that historic looking at Cyprus). You, I, and most of your readers will know the damage that excess inflation does to an economy, but faced with the fairly draconian measures that are the alternative, which will the political puppet masters choose?

      Arguably the last (full) Tory government were punished in three elections for the impact on houseowners of the houseprice crash that started in 1989 and ran through to 1997, and the negative equity consequences. And they didn’t help themselves with contributory pain like Black Wednesday. Why will they intentionally go through that pain again, when (in their minds) unleashing the retail inflation genie replicates the “success” in wholesale financial markets of QE?

    • Hi Dr Morgan

      Thanks for your reply.

      I agree with virtually all you say but let me be more specific as to what I think the response might be (extend and pretend 2!).

      First I think more QE, no matter that it makes little or no difference and that it is probably harmful in the long run.

      Secondly I would not rule out yet more attempts to underpin the housing market as stupid as these are.

      Thirdly the government could supply convertible loans to the banks to stave off insolvency and convert to equity in the future. One point I think you made is that, in your scenario, deposit insurance would take effect and depositors would be safe ( presumably up to the 100K Euro limit ). I do wonder in the case of a more widespread failure whether deposit insurance would be affordable by the government and that it might be forced to reduce coverage, I realise that this reinforces your original view that something different needs to be done this time but it is a possibility and force majeure…. There is also the squealing that would take place from those above the limit. However, this also reinforces the need not to declare insolvency by the banks.

      I also think you underestimate the inertia of the public who will certainly grumble if the bankers are let off the hook again but what can most people actually do about it – very little, indeed depressingly little – I suspect?

      Where we have fiat money and a printing press there is always a choice, albeit a wrong one.

    • Badger

      They might very well try – it is ironic, by the way, that the BoE (and other CBs) obsess over retail inflation and ignore asset price inflation, which tends to be the real problem.

      But can they do it – even if they’re prepared to destroy the currency? I get asked this in relation to energy prices. The answer is that there are huge deflationary pressures because, hidden behind stats, economies are shrinking fast.

      Take Britain as an example. Over the coming five years, even officially (!), the UK will see £500bn of nominal “growth” funded by £1,000bn of new debt. Shift from a “turnover” (GDP) to a “cash flow” measure of the economy and you have shrinkage, not growth. In China, GDP has increased by $5 trillion since 2007. Over that period, debt (excluding inter-bank) has grown by $15 trillion – so, on a cash flow basis…….?

      So, which version is true – “growth”, or cash flow weakness resulting in a dangerously weak balance sheet? Well, real-world parameters – such as commodity demand and prices, shipping rates (a key indicator for trade) – suggest very little real growth.

      So bad is this that we face a deflationary environment – despite QE and other inroads into the solidity of money value – and this might make inflation hard to achieve – hard, that is, unless we go completely bonkers (or desperate) and try helicopter money (for which the latest term in the UK is “people’s QE”). Mark Carney and Janet Yellen as disciples of Corbynomics? Even Japan’s kamikaze economics haven’t created inflation, despite huge QE and devaluation.

      None of which is to say they won’t try. But the costs of doing this would far exceed just taking the hit to banks and the property market.

    • Bob:

      Yes, there does have to be a very strong likelihood that they’ll try yet more QE, and propping up the property market yet again.

      But will it work? The first crisis resulted from three decades of reckless borrowing. The “borrow our way out of a debt problem” answer seems to have speeded things up – this time, the crisis will happen after seven or eight years of this. So I wonder about the durability of working this con-trick again. This is why I suspect that trying this might fail, perhaps in a matter of months,or even weeks.

      I’m sure governments would have no compunction about haircuts on deposits, blaming it on “extreme circumstances” and “the national interest”. It occurs to me that they cannot apply that to National Savings (where technically it would be a default).

      Convertibles are certainly a possibility. But the problem surely is credibility, with public debt already huge, and with QE to be borne in mind too. Also, the UK is hugely dependent on vital imports, funded at the moment by overseas borrowing and asset sales – what happens to this if trade partners lose faith in the currency?

      So yes, I think they’ll try all the things you list. I’m just not convinced it’ll work. I take your point about inertia, too. But I wonder what public reactions would be if the central payments “spine” of the system were to crash.

    • I am not sure that house prices will be such a sacred cow this time. A good swathe of people are waking up to the idea that high prices are bad for their families. Both the young that can’t afford a family and their parents who are missing out on grandchildren. GO’s knifing of BTL took me by surprise and I am no longer so sure of knowing his and Carney’s motives. It is possible that they and the teams around them have as much clue as we do and are manoeuvring within the limits of their institutions to not end up with all the Egg over their faces. GO in particular has an eye to future PM pretensions and with the next election 5 years away may have some room to wield the knife.

  3. “Borrowing for consumption rather than investment” – I think this encapsulates a large part of the wider problem that is the human condition. Self interest, greed, getting more for less, cutting corners, leaving the hard choices to others. These are the conditions that have led to the rise of the ambitious, self-aggrandising political classes who simply offer greater inducements for more votes and more party funding.

    The options above could certainly provide an immediate course of action but the consequences for the wider population will still be grim. Higher unemployment, lower GDP, beggar-thy-neighbour global manoeuvring – static or negative growth, less money and ever more mouths to feed.

    I don’t see any political leader at home or abroad with the will to achieve a fair and proportional solution. In consequence, if we are expecting a hard landing, I expect the Government will seek even greater control of civil liberties via the small print of the CCA. I also wouldn’t be surprised if there was a move towards a cash-less monetary system in which any income can be taxed at source and savings, if necessary, confiscated. Undoubtedly, this will be sold to the the electorate as “fairer and more equitable”.

    In short – the death of democracy. My sincere apologies for the gloomy forecast!

    • You are certainly right about short-termism and greed, though this doesn’t seem to be the same everywhere. For reasons which I can’t entirely fathom, this seems worse in the UK than elsewhere. Every conversation I get involved in or overhear seems to be about either money, angst or both ( I recently overheard two teenagers discussing – with no correction from their parents – how wealthy they would be when their grandmothers pass away). A recent article on CapX, though pro-capitalist, bemoaned the obsession with posessions and celebrity.

      I think you’re right that the outlook for the population will be grim – they weren’t exactly great last time, and all we;ve really done is overcome the symptoms of the drug (borrowing) by taking bigger doses.

      But, from a UK perspective, what is the range of possible outcomes when we get 6% of our GDP from foreign creditors – we backstop this with asset sales – and depend (officially) on (a) pushing house prices up even more, and (b) going on a credit binge, just to keep growth slightly ahead of population increases?

    • Not forgetting (c) – the guestimate of profits derived from prostitution and drug-dealing! You opened my eyes in your excellent book to the US manipulation of GDP via “increments”. As you rightly say, on any reasonable benchmark of GDP, we’ve all been in a recession since 2000 – but nobody wants us to know.

      We all seem to glibly accept the devious nature of these manipulations as well as the Government’s increasing ability to monitor our movements and transactions because it’s easy (lazy?) to do so.

      It is this culture of blind, convenient acceptance that leads me to believe greater control and surveillance will be the Government’s response. By extension, would that lead to the cash-less economy we keep hearing about? I believe it will – more control, less liberty – goodbye democracy!

    • Indeed so, and thanks – one aim with the book was to unmask some of the dodgy bits of GDP (such as “imputations”) and government debt.

      I agree that governments are extending surveillance, though I think the main reason might be fear of popular unrest when ponzi economics falls apart. One very shrewd US billionaire warned recently of “pitchforks” unless the system becomes fairer and more inclusive.

  4. There is a good American site – Shadowstats – which attempts to provide an alternative to dodgy US economic statistics. I remember when you were at TP you were attempting to do something similar in the UK, at least with the inflation measurements. Is this still happening? A lot of the major economic changes affecting people seem to be very gradual but progressive and as a result complaint is muted – one of the features of compounding (or at least the negative version of this). I wouldn’t be surprised if there were a section of the treasury devoted to finding painless ways of removing people’s entitlements. A good example is the change in the way pensions are uprated (RPI to CPI) which almost slipped through unnoticed in GO’s budget speech but clearly has had and will have a massive effect. It seems that people will put up with a lot but as you say the pitchforks will be out if there is a massive collapse.

    • I have a high regard for John Williams’ Shadowstats. He is a vital voice. His guides to inflation, GDP etc are available for download.

      At TP, I developed the UK Essentials Index. It still continues. Since TP closed the research operation (that’s why I left), they kindly let me keep it, and the UK Economic & Fiscal Database as well.

      I update the Essentials Index quite often, but don’t generally publish it much.

  5. UPDATE

    FT is reporting growing numbers of Chinese shadow banks asking for government bail-outs. This follows a string of state rescues of bonds facing default.

    This reminds me of the trickle, which turned into a flood, in US sub-prime.

    Chinese stock market fell 6.15% yesterday.

  6. I go with Bill Bonner’s prediction that hard cash will be extremely scarce – in fact it seems likely we will have a Argentinian (and latterly a Greek) experience. It might be wise to have 12 months living expenses in cash in a safe at home (yes I know it will tiresome explaining to the bank teller! Just say you’re buying antiques for cash discount).

    As for social observations – smart phones – dumb users – I can’t really go to live performances anymore because of the wretched people filming it. Well done to Cucumberpatch for making a stand. Personally if I had seen it happening I would have stopped performing.

    Why is it that a state broadcaster does not show any culture – I remember not so long ago The Crucible on BBC1 at peak viewing time! Radio 3 is totally ruined. Proms hype ad nauseum…

    • Good advice, I’m sure. News from China – shadow banks asking for bail-outs, and the state back-stopping bonds – makes me feel the new “Lehmann moment” may not be far off.

      On smart phones, etc, I remember people queueing for seven days and nights – in a London November! – just to be first to get the new iPhone. What is it with these people?

      Someone – I stress it was NOT me – wrote that he knew the ’08 crash was coming when he saw “lads going to Prague for stag-nights and shop-girls hiring stretch limos for a night out”.

  7. One of the ways in which the forthcoming crisis will be entirely different is that as well as banks, it is Governments who are bankrupt this time. Only 94% of the UK population actually understand the difference between “debt” and “deficit”. The underlying debt has been spiralling under Osborne, spiralling in the US and much of the Western world.

    I believe the bank issue will be passed to depositors on this occasion (as Dr Morgan says the taxpayer route cannot be repeated). The EU has sped through the passing of a law which makes bail ins the new bailouts. They got away with it in Cyprus, they believe they can get away with it again. In addition, if they thought they could do it they would stop bank runs by switching to a cashless society. Personally I don’t think this can fly for at least another 20 years based on access to technology and understanding of same within certain sections of society. However, they may bring in capital controls – you can only take out £x per week in your account. They may then apply negative interest rates in the “national interest”. After all, that’s what has been happening in certain markets already; we pay to park cash.

    As to the issue of Government debt, history shows that politicians will always take the edifice down with them. In fairness to Osborne he is implementing a fierce spending review this Autumn, albeit against a backdrop of ever-increasing debt. If Government really wanted to get spending under control they have no option but to tackle the state pension – unfortunately that would lead to the Juncker phenomenon: we all know what to do, but no one could be voted in after they had done it. I therefore expect the pips to be squeezed all round (the Summer Budget was one that Brown could have written in its stealth) over the coming years and property is a sitting duck – council tax re-banding for example is just around the corner after an X year freeze. This will be against a backdrop of deflation in my view, and the combination will tip many over the edge. Certainly now is the time for low leverage, cash (not in a bank), waiting for fire sales.

    I apologize that this isn’t more positive. I really do think this is going to be much more serious of 2007/2009, just as the Greek debt situation is so much more serious now than if they’d grabbed the bull by the horns in 2010.

    • We’re both being typically British aren’t we – apologising for the less than positive/gloomy forecast ahead!

      I agree with almost all you say but I need to challenge one of your assumptions. The ID card proposal developed under the last Labour administration was canned by the coalition in 2011. However, the technology has been developed, refined and is available – it could be implemented within a 5 year period or rushed through within a year if an emergency required.

      We know what can be done in an emergency – it has already been enacted within the Civil Contingencies Act (apologies for banging the same drum – thrice!).

      If the alternative involves pitchforks – remember the riots in 2011 when the targets were TVs, Nike etc. – all non-essential goods. Too many can’t do without Heat magazine, let alone central heating. If the supermarket shelves become bare, it’s “dog eat dog”. The political class are aware of the potential and will default to their tried and trusted route of central control.

      The logical extension is a suspension of democracy.

    • The British conservative government is as incompetent as was Labour. Both sides of politics aim for budget surplusses, but all that achieves is a recession because a budget surplus is exactly equal to a non government deficit. It’s an accounting identity. A non government deficit means money is withdrawn from the economy [to service the government surplus] therefore spending goes down and wages and investment goes down with it. The Only way money enters the economy is by government deficit spending. Money is IOU’s so the government spends to meet the IOU’s in the system. No IOU’s = no money. For the economy to grow it needs money. Obvious,yes?

      You need to rethink your ideas and stop falling for false narratives that abound in finance .

    • False narratives? The law of diminishing returns maybe or the inability to repay the interest on all your accumulated IOUs? If you need an example of the suspension of democracy, think Greece – true story.

    • I cannot agree there, in that, as I experienced it, the Blair-Brown government was a total disaster – it rode a debt-funded boom, spent up to it as though it was “real” growth, and dragged us into a catastrophic war in Iraq. The Conservatives aren’t supermen, but being worse than Blair-Brown would be really, really difficult!

      My problem with MME is that it doesn’t seem to have convinced anyone, in government, business or finance. So, even if theoretically logical, it won’t be what guides policy and – especially – reactions to a crisis. Rightly or wrongly, decision-makers will frame their actions within “conventional” assumptions. I don’t deny that they might be wrong to do that, but I think it’s what they’ll do.

    • There are some extremely good points here.

      Spresident, do 94% understand the difference between debt and deficit? Seems remarkably high to me. You are right that, this time, one big difference (mentioned in my article) is the much higher level of government debt pre-crisis.

      Before the last crash, UK govt net debt was 38% of GDP – now it is c80%. That 40% increase is worth c£750bn based on current GDP – that’s ammunition that the state has used and no longer has, unless it pushes the ratio to 120%. This is all about credibility – how much faith will markets retain in the UK and GBP if debt ratios soar (again), money is printed, the govt tries to rescue banks, and simultaneously prop up the housing market?

      For borrowing, rescues and QE, the really critical question is confidence, and finding its limits.

    • Apologies – Only 6% understand; 94% do not understand. Yes, I would be astonished at such levels of fiscal acuity. I totally agree it’s all about confidence and that has been in short supply for some time. We’re nearing tipping point.

    • “Only 94% of the UK population actually understand the difference between “debt” and “deficit”. Wow!! as many as that ? I guess you meant 94% Don’t know the difference. Tinkering with pensions will not save the country, destruction and reformation of the banks will.

  8. Tim, What does it mean saying governments are far more indebted now than they were in 2008? I can understand total debts, such as Government plus bank plus private debts are a much higher today, along the lines of your graph 3.4 in “Perfect Storm”but the government debt portion is a] not hugely bigger and b] not true debt, but investor savings accounts held in the Fed reserve system.

    Probably the real issue is the non government non private credit/debt circulating off balance sheet in the banks and shadow banks, such as the derivatives industry, with a gross notional value nobody knows but is estimated to be from $700 Trillion to $1.4 quadrillion.

    One wonders why the Minsky Moment hasn’t already happened? Clearly the derivatives market is kept clear of any accountability, and losses are just absorbed by investors as part of the risk of joining in. So we are left with loans and other debt instruments that are on balance sheet to evaluate the risks with sovereign government debt [ note – non sovereign government debt is in the commercial banking sector] and the derivatives/shadow banking excluded.

    This should be taken into account but likely isn’t. In which case there might be more fiscal space than is otherwise assumed to keep us going.

  9. On the last part of your article “what do we do now”your ideas are interesting, and new to me. I have been entertaining notions of Debt Jubilees, which have a similar scope. David Graeber in “Debt The first 5000Years” first said that in the last resort it would be a way out.
    And others like Steve Keen have joined in.

    I doubt banks are keen on everyone understanding how they get their money to set up loans, because the funds are pure credit creation, so called from thin air. They don’t lend any of their reserves. They cannot lend without borrowers either.

    The implications could be profound. A debt jubilee could just wipe out all the banks fiat capital, the loan amounts, which are liabilities. The assets are the loan documents. Borrowers would no longer owe real assets to pay off fiat money, but the banks could keep the interest paid as that is basically all they have in the end anyway. Banks would have to wipe the derivatives market, which is just a casino anyway. But the numbers in the nations’ accounts would be dramatically reduced. Banks could survive, but much chastened. The whole system doesn’t have to fall over and depositors would not be affected in so far as they didn’t indulge in money markets.

    How does that sound to you, Tim?

    • It’s arguable that ZIRP has been a form of debt jubilee over the last six years at the expense of all savers and not just at the cost to the lenders (the bankers always win).

      Also a debt jubilee would, I guess, cost a great deal of money to be at all effective to the extent where ordinary depositors might have to take a hit (deposit insurance?)..

      There is also the effect on moral hazard; let’s face it it would be a green flag to many to run up even more debt than is now the case which is the last thing we need.

      An interesting potential solution but perhaps trickier than it first appears..

    • The problem as I see it is that debt is complex – it is asymetric, and has rankings, so one can’t say “we’ll cancel both junk-bonds and AAA debt equally” without considering rankings. Likewise, a government can hair-cut deposits in banks, but if it does the same to corporate bonds it (technically at least) bankrupts the issuing corporation, and if it hair-cuts government bonds then, in effect, it defaults.

      The derivatives market is vast – a great deal would net off, but losses would still be enormous.

      Also, some derivatives are used for their legitimate, original, non-speculative purpose, which is hedging future trade positions – if these “genuine” hedge positions are forfeit, trade could be very badly damaged.

  10. UPDATE

    I’d like to draw your attention to an FT article today by Stephen King of HSBC.

    What he’s saying is that China has carried the global economy since 2008, but can no longer do so.

    He surely has a point. What would have happened, without China, to commodity demand after 2008? Or exports from other countries? Or global demand for cars, industrial goods and so on? Could the US have issued so much Fed debt if China hadn’t been a buyer?

    By letting the RMB appreciate, China has granted the rest of the world the stimulus of devaluation. China’s net exports have shrunk from 10% to 2% of GDP, i.e. a big rise in net imports.

    He’s also saying that China can no longer carry the economy in this way – as we know, of course, from the debt figures set out in my article; from worrying trends in Chinese shadow banking; from sharp declines in volumes (vehicle sales, factory output); from the scale of over-capacity; and from huge capital outflows from China.

    So, if China can no longer carry the burden, what happens?

    • Hi Dr Morgan

      I thought the RMB had depreciated rather than appreciated?

      If this is the case and in the context of worldwide surplus capacity won’t this compound the deflationary forces in the World?

      If this is so and we do indeed have deflation and not merely disinflation then this will certainly unchuff many central bankers who will watch as stagnation takes hold and debt ratios go up simply compounding all the many problems we have.

    • Until recently, the RMB has been appreciating since 2008. Just recently, though, China has been reversing this a bit.

      And yes, the main alternative to a crash-and-reset is prolonged stagnation. My own view is that crash-and-reset looks likelier – and might indeed be better than a long period of stagnation.

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