Smoke and Mirrors
Britain enters 2010 in a critical fiscal and financial position.
Much has been written, spoken and discussed about the strategy of stimulus via so-called Quantitative Easing or QE: now, most commentators glibly state this exercise is “Uncharted Territory” and no one knows how it will pan out.
I very much dispute such conclusion.
QE is simply creating money out of thin air, in the hope that piling supra-liquidity into financial markets will somehow act as a magical economic stimulus and return the economy to growth from recession.
Well, such could only work – to a limited degree – where the extra liquidity was immediately filtered down through the money markets and banks into direct business and commercial activities.
Unfortunately, Brown’s much vaunted “Economic Miracle” was predicted mainly on twin drivers: an insane and wholly out of control housing market and the import, distribution and retailing of Asian tacky “Must Have” toys. Many sold on credit via credit cards and other unsecured floating rate obligations.
Clearly this stimulus has not happened and indeed is not happening: the reverse still pertains. Britain still languishes in deep recession. SMEs in particular (Small and Medium Sized Enterprises) are starving for want of cash: cash to fund their sales ledger, for stock, for investment.
SMEs are a critical component of Britain’s production and employment, creating circa 50% of private sector GDP and accounting for nearly 50% of private sector employment.
What QE has achieved is a process whereby banks and other financial institutions have turned in gilt edged securities (UK Government Bonds) and other investment class fiscal instruments for immediate cash: which they have then punted on the equities markets! In other words they have used this liquidity to simply invest in what already exists.
It is thus therefore no surprise that despite a dire underlying real economy, the stock market has risen and risen: institutional investors have been scrambling for decent class equity assets.
However, as history shows – as always! – when fiscally troubled nation states endeavour to address core economic problems by magically creating money the end result is chaos, collapsed currency and economic disaster.
The best example of such insanity is of course the Weimar Republic and their running the money printing presses 24/7 back in the 1920s.
Really, Britain’s government and Bank of England’s “Strategy” can be likened to ourselves; if we were stupid enough to offer our bank manager a cheque drawn on his bank’s account to pay off our overdraft!
The Prodigal Son
Unfortunately, the programme of QE which will finally mean the creation of circa £250-275 billion of magic electronic money is not the only dynamic affecting Britain’s fiscal affairs: since Teflon Tony Blair first walked through the doors of number 10 Downing Street, New Labour have been spending government funds as if the Golden Goose had taken up residence in the gardens!
As the economy contracted, naturally enough net tax revenues fell and fell.
Yet undismayed the New Lab machine continued as before, taking total government spending to a probable 47% of GDP for fiscal 2010.
Now with diminishing tax revenues as the economy shrank into deep recession, and greater calls on public finances as unemployment rose to nearly 2.6 million, government had to increase and increase its PSBR (Public Sector Borrowing Requirement): this is carried out mainly through the sale of government bonds – Gilt Edged Securities or simply, Gilts.
(Short term –91 Day– debt is funded by the Bank of England issuing Treasury Bills)
Whilst all the bad news multiplied, with the collapse of Northern Rock and the effective insolvency of RBS etc, government was also minded to support these troubled institutions: as well as secret loans to British banks totalling over £600 billion (Which have only recently been admitted), the Bank of England was throwing cash around to add liquidity well before the spavined concept of QE was first mooted.
According to government’s own National Audit Office, the bank bail out cost another £850 billion.
However the total cost of eventual support will exceed this by as yet, an unknown amount: time stands still when you’re having fun – with someone else’s money!
Sovereign Debt Crisis Builds!
Now unfortunately for the British Government, a sovereign debt crisis is building rather quickly in global capital markets.
Greece, in particular has suffered a significant creditor status downgrade: and following in its wings are probably Ireland, Spain and Eastern European members of the Eurozone.
As the late 1970s showed when banks over-dosed on emergent nation sovereign debt through the Eurobond market, using just interest rate as a decision fulcrum was a bad idea!
Indeed it was in itself, a precursor to the recent Sub Prime debacle.
The scheme went like this: Mexico for example, is a very bad credit risk: Mexico wants a $100 billion: the market rate is 5%: they cannot afford to borrow and repay: so we’ll charge them 8% for the extra risk!
Guess what? They defaulted. Surprise.
Bond markets are presently very edgy: one of the largest holders and investors in bonds is Pimco: who are already giving notice of shedding government debt from their portfolio.
Thus the capital markets are going to be rather cynical about any large quantities of fresh new government debt.
With its fiscal affairs in total disarray and the need in 2010 to float circa £ 225 –250 billion of fresh new bonds, Britain enters this new year ill-placed to approach credit markets with any degree of confidence: indeed, both Moodys and Standard Poors have indicated a potential downgrading of UK’s creditor status from AAA: not much of a surprise really!
Throw way The Textbooks!
At this moment in economic history, textbooks on fiscal and economic theory are useful for propping up uneven tables or sofas with bad legs.
Traditional theory dictates that as a nation state’s currency value falls, then exports are cheap and imports too expensive, thus Current Account (Balance of Trade) self-corrects over time, as imports are too dear and exports ultra-competitive.
Well, that’s a nice theory: all provided one’s economy has not been predicated on over-reliance of the import of essentials; and exports can be led by a thriving and energetic industrial base ready and keen to export rafts of desirable goodies!
Britain is far too over-reliant on essential imports such as energy and foodstuffs: as well as essential manufactured items such as all hard goods relating to ICT. (Information and Communications Technology).
And since the Thatcher government, which presided over the wholesale destruction of essential core precursor activity such as coal mining, steel smelting and processing, there is little true industrial manufacturing left on which to build energetic export-led economic revival.
UK Current Account:
Source: ONS – http://www.statistics.gov.uk/cci/nugget.asp?ID=194
As will be readily seen from the above graph, Britain has been in deep Current Account Deficit for many years: which adds another fiscal pressure, since this has to be funded, somehow.
On the top of everything else!
Sterling Crisis Approaches
All current developed nation’s currencies are issued as Fiat Currency: i.e. there is little asset backing from such as gold bullion and the value and thus exchangeability of such currency on the global Forex markets relies on creditworthiness and stability of the underpinning economic base.
Investors take into account two facets: the forward view of capital loss and the rate of interest they can receive.
A Forex investor’s downside problem is called “Exchange Risk Exposure” (ERE): the risk that when they change from one currency into another, they are exposed to capital loss if the new currency depreciates against the currency used to purchase the investment.
Exchange Risk Exposure can be and in practice is often offset by the rate of interest received: thus if the ERE is above average, then the investor will demand a compensating high rate of return.
As the markets examine Britain’s high hopes for further hundreds of billions of gilt funding and feed through the dis-equilibrium of the Current Account (Balance of Trade), sterling must depreciate still further against the US dollar and the Euro: and significantly so.
Which then, of course, exacerbates the Current Account still further.
The mad and rapid expansion of Britain’s bureaucracy under the helm of New Labour has created a hugely untenable position for Government: they need now, urgently, to set in motion swingeing cuts to the public sector: which will trip a disastrous union reaction and inevitable, even higher levels of unemployment, redundancy payments and benefit dependency.
And all at a point where tax take is still falling. And government borrowing is set to try and continue at record levels.
Some commentators forecast large tax hikes: however, it is difficult to see quite where. Attacking the obscenely wealthy is perceived as the politics of envy and tends to suffer a rapid reaction. Already, high earners in the financial services sector are making plans to move their centres of operation abroad.
Hitting Middle Englanders one again would mean those on the bare cusp of survival (Many of whom have seen their net incomes fall and fall over the past four years and are invariably suffering pay freezes in any case) would fall into deep financial problems.
Tax businesses? Apart from the very large, they are all experiencing retraction in revenues and profits: and many are in negative growth or even loss.
The bottom line conclusion then must be that in the first quarter of 2010, sterling will need urgent support: and the single factor of support essential will be a significant hike in interest rate.
The Bank of England under government pressure have insisted they keep Base Rate at just 0.5%. However, there has been a growing disconnect between Base Rate and LIBOR (London Inter Bank Offered Rate: the rates charged by banks lending to other banks and the most accurate metric of the real market).
1. Q 1, 2010: Growing Sovereign Debt Defaults and Re-Scheduling.
2. Britain Sovereign obligor status heavily downgraded.
3. Sterling drops like lead; balance of trade deficit critical.
4. Chancellor Darling’s plans in ruins as global capital markets slow to take up further debt.
5. Owing to .3. & .4. Base Rates rapidly rise. Essential to defend Sterling and attract sufficient investors into British government paper. Base Rate will probably hit 10% for a time.
LIBOR will track and probably always exceed Base Rate: gilts offering far less will drop capital value rapidly: as will CDs.
6. Housing market implodes: large levels of Negative Equity and Foreclosures Q3 & 4.
7. The reality of thin balance sheets of main Eurozone banks and their critical exposure to delinquent Sovereign Debt; plus rapid turnaround from Recession to Depression in tenuous member economies, particularly Greece, Italy, Ireland, Spain, Malta, Cyprus and Eastern European members etc and their lack of autonomy to engage in such as a QE fiscal stimulus, and the determination of the Bundesbank-centric ECB, cause growing rift in Euro mechanism.
8. UK Unemployment hits and exceeds 3 million.
9. Probable Hung Parliament and conclusion a coalition by end Q2/beginning Q3.
10. Equities market take a bath as they head South by end Q3 if not before.
11. Gold hits and exceeds $2,000/bullion Oz. By Q2/3. Causes: Continuing economic problems in the USA: Problems in Eurozone caused by problem states: Sterling Crisis: Sovereign Debt Defaults.
Happy New Year?
Michael C Feltham