Saturday, July 19, 2008

Where will the money come from?

Via Iain Dale, it seems that the wheels really are looking slightly loose economy-wise, as the government's borrowing requirement soars.
Public sector borrowing rose by more than expected in June, official figures have shown, suggesting the economic slowdown is hitting government coffers.

Public sector net borrowing (PSNB) was £9.16bn, a record amount for June and more than analyst forecasts of £7.4bn.

Borrowing so far this financial year has reached £24.4bn since April - the biggest quarterly figure since 1946.

When dealing with government figures, the totals are so enormous that they almost defy belief. However, as we know, declared public sector debt is over £550 billion. This is nearly half of our annual GDP.

And this begs the question of when—and how—this money is ever going to be repaid. Do our governments intend to repay the borrowing? Or do they intend to stay in debt in perpetuity? And is this any way to run an economy?

No, it isn't.

And the answer is that, at current levels of government spending and taxation, this money will never, ever be repaid. Even were you to cut government spending to a fraction of the current levels, then this debt would take years to pay off.

Successive governments have put us all into hock to the banking system and so, no matter how well we manage our own personal finances, we are all still under obligation to those self-same banks. And, as I have said before, I don't like being under obligations because pipers can call the tunes.

There is another issue here, of course, and that is the issue of inflation. Tory Heaven recently wrote eloquently about this issue, pointing out that inflation is not caused by wage rises (as the government keeps attempting to insist).
How does the Government respond to such claims? By trotting out the old socialist lie: that wage rises are the root cause of inflation. This erroneous view was exposed in the early 1970s by the late Enoch Powell, who, as the lone monetarist politician of the time, consistently showed what later Conservative Governments came to understand when they successfully tackled inflation: that inflation is caused by an increase in the money supply, not by rising wage levels. If a Government has, say, £1 million pounds in the bank, which it can either pay in increased wages to workers or else to spend in building hospitals or funding other Government projects, there is nothing to recommend any of these options over any of the others so far as a possible effect on inflation is concerned. It is only if the Government borrows money, e.g. from foreign banks, to finance any of these activities, and so increases the amount of money in circulation, that more money will be chasing the same amount of goods and services, thus creating inflationary pressure. If the money supply stays the same, it matters not whether the Government's £1 million is spent on wages, hospital building, or indeed remains in a bank account to be used for investment by the bank in various ways: there is no effect on inflation.

Cato then points to Zimbabwe, which is interesting because I also held up that benighted country when I last attempted to explain what inflation was.
This whole principle is an absolute fundamental, of course. Roughly speaking, when countries adhered to the Gold Standard, the currency unit represented a fixed proportion of the gold in the national bank. Thus, if you printed more currency units (without increasing the amount of gold) then, naturally, each unit had to represent a smaller proportion of the gold reserves: hence each currency unit became worth less. The currency unit has less actual value and thus does not have as much purchasing power: this is essentially what inflation is. This system, of course, put massive constraints on borrowing (hence our leaving in order to be able to fight a World War).

These days, as I understand it, the Gold Standard has been replaced by a perceived worth of the country's economy (a bit like the perceived worth of a publically-listed company) which can be affected by a vast number of different factors. However, as a rough rule of thumb, the idea is the same: the currency unit is worth a proportion of that perceived economic worth.

In the case of Zimbabwe, the government's insane policies, poor harvests, massive borrowing, poor property rights and shattered infrastructure has undermined confidence and ensured that the economy's perceived worth was already low; so, naturally, the worth of each unit of currency (the Zimbabwean dollar (Z$)) has also dropped in value compared to other currencies.

However, the Z$ has lost even more of its worth because the government keeps printing money thus ensuring that each currency unit is worth even less as a proportion of an (anyway fast-falling) perceived total economic worth. And hence you get hyper-inflation.

As I said at the time, I am more than happy for any economist to pull apart, or enhance, my rough and ready explanation above. However, this is how I perceive inflation.

And there are, as I understand it, two main ways in which the money supply can be increased. First, the government can simply print more money (does the Bank of England have to authorise this?). Second, banks create more money through fractional reserve banking. Both of these methods increase money supply and therefore inflation.

As such, the government's increase in borrowing is likely to continue stoking inflation, which is running rather high in any case. This is, of course, a problem in the credit crunch; since the amount of borrowing that can be done by individuals or businesses is much less, people are going to end up worse off. Businesses cannot borrow to increase wages (let's leave aside whether that would be good business practice or not), people have effectively less money to spend and cannot thus buy as much; as such, revenue to businesses falls and further ensures that they cannot increase wages, people can buy even less, etc. etc. Hence, the country spirals into recession.

The traditional way in which to curb inflation is to increase interest rates; this discourages borrowing and thus decreases the increase of the money supply. The entity currently responsible for setting these rates is the Bank of England, which is also charged with controlling inflation.

I, and many others, have opined that the one good thing that Gordon Brown has ever done was to make the Bank of England independent. Having cogitated on this for a few days, I am now not so sure that this was a good idea.

When it was made independent, the Bank of England was charged with keeping the inflation rate (as measured on the CPI) below (I think) 2%: all well and good. However, the indepdendence of the BoE has meant that it is now no longer linked to the government (at least in theory). What this has enabled Brown to do is to carry on spending massively whilst being able to absolve himself of responsibility for the inflation rate.

"Look," says the Gobblin' King, "the rate of inflation is nothing to do with me: I told the Bank of England to keep it down. It's independent, you know, I can't do anything."

The problem is that the BoE has no way of curbing the money supply beyond raising interest rates. But this is becoming ineffectual. Why?

First, the government is one of the biggest spending entities in the country; further, more and more of this spending is predicated on debt (nearly 40% of national income, in fact). However that debt is generated, it increases the money supply and thus inflation. The only thing keeping the government in check was the Chancellor's so-called Golden Rule and Sustainable Investment Rule.

Quite apart from the shenanigans surrounding whether or not these rules have actually been kept to (and whether the government intends to "officially" break them), they are predicated on the promise of one man; worse, they are predicated on the promise of a politician.

Even worse, the rules were made up by a politician who has promised to bribe the electorate invest in public services and eradicate poverty, no matter the cost. This is not reassuring. If nothing else, if one man can make the rules, then one man can break them.

The second problem facing the BoE is the second source of money supply; the private banks. The interest rate issued by the BoE is the rate at which the central bank will loan money to the private banks. Since the private banks rely on the central bank partially for loans but, more importantly, for security—as the "lender of last resort"—should they run into trouble, the rate at which the BoE set interest rates did act as a reasonable guide to the banks' interest rates.

Unfortunately, the Northern Rock debacle has shattered that relationship. The Rock had been doing some dodgy investments and was looking at a short term liquidity problem. From people who know, I gather that the amount borrowed by the Rock from the BoE was simply to ensure that they had the required actual money reserves to back their lending. Whilst the management were undoubtedly stupid, this is actually how the "lender of last resort" concept is supposed to work.

Then came the disaster: someone leaked, or people noticed, that the Rock had borrowed from the BoE. People lost confidence and the run on the bank started; what should have been a minor blip caused by mismanagement but dealt with through the provisions intended, became a major banking crisis. People started withdrawing billions a week and the bank's liquidity requirement soared, leading to yet more borrowing from the BoE and then, as the cash kept rolling out, eventual effective nationalisation.

Coupled with the US credit crunch (caused by yet more bad management), this caused a loss of confidence in the banking system; the trouble is that the credit crunch was also affecting our other large banks, who had considerable exposure through unwise loans, both directly to borrowers and to the lending banks. Normally, the banks would borrow from the BoE to shore up their money reserves but after the Northern Rock debacle, they dare not do so.

Any rumour that one of the big banks had had to borrow, like the Rock, from the lender of last resort might cause a similar run on the bank. As such, the other banks dare not borrow from the BoE; and this, of course, has led to the level at which the BoE sets the interest rate to be increasingly irrelevent.

We saw this when, a few months ago, the BoE dropped interest rates but the banks did not drop their lending rate. That is because, whilst the BoE had dropped its rate, the LIBOR rate—that is to say, the rate at which private banks lend to each other—had actually increased.

Since no bank dared to go to the BoE for money, the only lending rate that was important to them was that of the LIBOR; as such, the BoE rate was irrelevent and its main tool for fighting inflation was useless. And, at this point in time, this continues to be the case.

As such, the Bank of England has no ability to fight inflation; the PR fiasco that was Northern Rock means that it has no ability to control the private banks (and they have less money to lend and all money is at a higher rate than a few years ago) and, being independent, the Bank of England has no control over the other big debt creator—the government.

This is obviously not good. We are faced with a contracting money supply through the banks which will bring economic stagnation. At the same time, we are facing rising energy prices and a government that is borrowing at an increased rate.

The contraction of lending should lead to less increase in the money supply and thus keep inflation low. However, it is not just the government's borrowing that we have to worry about.

The loss of confidence in the banking system (and, indeed, the government's fiscal competence) has caused a loss in confidence in UK Plc. If we refer back to my explanation of inflation above, that means that UK Plc is worth less overall. As such, each individual pound (or share) in that economy is also worth less (which is why the pound and the dollar are falling in value against other currencies).

So, whilst the overall money supply might well be contracting, the lower net worth of the economy as a whole means that each pound spent is worth less and thus we have a further inflationary pressure. And this is compounded by the fact that our one absolute essential, energy supply, is becoming more expensive and this is also causing effective inflation.

I believe that this sorry state of affairs—economic stagnation caused by a contracting money supply coupled with an inflationary pressure on the money currently in circulation—may be what economists refer to as "stagflation".

And so, with the government still spending like a drunken sailor in port, things are not looking good on the economic front. But, as Fraser Nelson in The Spectator also believes, the NuLabour government may well be pursuing a spiteful, Scorched Earth policy; they can spend all they like since they are pretty convinced that, after the next election, the Tories will be left to pick up the pieces.

As such, NuLabour are spending like a drunken sailor in port who knows that he is to be die of cancer tomorrow morning.

Oh shit...


P.S. As you may know, your humble Devil is not an economist—in fact, I have never formally studied economics in any shape or form—so the above may be a load of old crap. However, if it is a load of old crap, do, please, point out why that is rather than merely stating "that's a load of old crap."


UPDATE: Timmy in the comments...
I'm 1) not an economist and 2) don't really do macro, which this is.

However, I'd add a couple of things.

The effect of an increase in the money supply upon inflation depends upon which money supply we're talking about. There's M0 (roughly cash), M1 (cash plus bank accounts) M2(M1 plus something or other) and so on. The lower the number the greater the effect on inflation of an increase. Zimbabwe's been financing their deficit by printing more money: an increase in M0.
We're doing it by govt borrowing (M3? M4? Can't recall) so the effect is a great deal less, there's much less leverage.

Secondly, you're sort of right about the BoE losing control of inflation because LIBOR is decoupled from the base rate now.

But it isn't really decoupled. What's happened is that the risk premium the banks are demanding from each other has risen. Thus LIBOR is higher, the gap between it and the base rate has increased. But it doesn't mean the BoE has no power. It simply means that the base rate has to be lower than it used to be in order to get the same amount of monetary loosening.

Imagine, the base LIBOR gap used to be 1% so the BoE set base at 3%. Now the gap is 2% so the base is set at 2%.....we get the same LIBOR of 4% and the same effect upon the growth in the money supply (because we don't increase M0 by printing cash, to us that's an insignificant part of our money supply. It almost all comes from the effects of fractional reserve banking... and yes, the BoE does take this into account when setting base rates).

And Matthew Sinclair over IM...
Matthew Sinclair: I think a few of your causal links don't quite work:

—the rising price of energy and food is crucial to inflation (and rent, as everyone tries to dump home ownership). I'm not sure how confidence in the banking sector would affect that.

I'm not sure the idea of the economy becoming less valuable quite works technically.

The Devil: Although it works for pound valuation?

Matthew Sinclair: It's a nice way of understanding it but I'm not sure it really describes what is technically happening.

We've had a supply shock—in the form of higher commodity prices—and have become radically more exposed to it thanks to a nonsense energy policy and taxing the North Sea into the ground. And biofuels constitute a political shock to food prices.

I think the finance problems are rather separate.

What you've got there are a load of banks that no longer see dodgy mortgages as particularly valuable and that fucks up all their capital bases, which they're now all trying to shore up.

So they won't lend to each other, because they're all trying to get the capital not to need to depend on mortgage backed securities etc.

Although Matthew advised that his points were a little chaotic, I have transcribed them (with a bit of minor tidying) lest I end up misrepresenting them...!

From talking to the two above, it seems that my thesis is not entirely wrong, as such, but that I may have misrepresented the degree to which it matters. However, I don't think that anyone would argue that we are just a wee bit fucked. As Matthew put it,
Every so often, at the moment, I try and count the number of ways our economy is fucked between now and 2020.

I tend to lose count.

As I said, oh shit...

UPDATE 2: the Daily Mash weighs in...
GOVERNMENT TO CONSOLIDATE ALL ITS DEBTS INTO ONE LOW MONTHLY PAYMENT

THE Treasury is to relax its rules on borrowing after seeing a television advert featuring Carol Vorderman.

Officials are examining how they can adapt the fiscal rules set in place by Gordon Brown over a decade ago, allowing them to pay off existing debts and borrow more, all at one low, low rate of interest.
...

The source added: "And if there's anything left over we'll use it to bribe the shit out of everyone just before the next election."

You know?—with this bunch of fucking clowns, I just wouldn't be surprised...

UPDATE 3: a good comment from The Fat Bigot (no, not Gordon Brown)...
It is important to distinguish between two different meanings of "inflation", one general and one specific.

The general meaning relates to inflation in the economy as a whole. The totality of prices paid cannot go up if there is no extra money. It is in this respect that inflation is necessarily limited by the money supply.

In this context inflation is primarily concerned with maintaining the value of the currency against other currencies. Therefore the money supply can increase in line with real growth in wealth because each pound remains exactly as valuable in real terms as it was before. An increase in money supply without an increase in wealth reduces the real value of each pound resulting in Johnny Foreigner wanting more pounds for each of his greasy groats.

The specific meaning is what is generally referred to as inflation - changes in the prices we have to pay for the things we need every day.

You can keep the money supply stable and thereby prevent systemic inflation but that is no consolation to Mrs Miggins when she pops into Mr Patel's Merry Mart to do the weekly shop and finds her staple diet of foie gras flavoured potato crisps has doubled in price.

The cost of Mrs Miggins' life is limited by the amount of money in circulation in her purse. An increase in the unit price of foie gras crisps must be compensated for by either the consumption of fewer packets thereof or gassing the cat to save on pet food. Either course has the same effect on her economy - she still has the same income but can now buy less with it so her standard of living is reduced. Within her little mini-economy the real value of the pound has fallen even if it has not fallen in the economy as a whole.

Increased wages are inflationary in the specific sense of the term when they result in higher prices for, in the present example, foie gras flavoured potato crisps.

They are inflationary in the general sense of the term only when they lead to the government pumping more money into the system to allow Mrs Miggins the extra cash she needs to buy both crisps and pet food.

That's a pretty clear explanation, I think. Consider me enlightened...

16 comments:

ukipwebmaster said...

One to watch out for:
http://www.youtube.com/watch?v=HBo2xQIWHiM

Tim Worstall said...

I'm 1) not an economist and 2) don't really do macro, which this is.

However, I'd add a couple of things.

The effect of an increase in the money supply upon inflation depends upon which money supply we're talking about. There's M0 (roughly cash), M1 (cash plus bank accounts) M2(M1 plus something or other) and so on. The lower the number the greater the effect on inflation of an increase. Zimbabwe's been financing their deficit by printing more money: an increase in M0.
We're doing it by govt borrowing (M3? M4? Can't recall) so the effect is a great deal less, there's much less leverage.

Secondly, you're sort of right about the BoE losing control of inflation because LIBOR is decoupled from the base rate now.

But it isn't really decoupled. What's happened is that the risk premium the banks are demanding from each other has risen. Thus LIBOR is higher, the gap between it and the base rate has increased. But it doesn't mean the BoE has no power. It simply means that the base rate has to be lower than it used to be in order to get the same amount of monetary loosening.

Imagine, the base LIBOR gap used to be 1% so the BoE set base at 3%. Now the gap is 2% so the base is set at 2%.....we get the same LIBOR of 4% and the same effect upon the growth in the money supply (because we don't increase M0 by printing cash, to us that's an insignificant part of our money supply. It almost all comes from the effects of fractional reserve banking....and yes, the BoE does take this into account when setting base rates).

Yes, a real economist would be able to show the gaps in this.....we'll wait until one comes along shall we?

Guthrum said...

I did economic History, and it my ears bleed. Since the 'cash' economy restarted in the 17th Century in earnest, governments have been upto all sorts of bull shit to con the country out of money. Each time they will always find some financial whizzkind to justify what they do.

What I fail to understand is how this shower think they can carry on fighting two wars at the sametime at enormous cost

Kay Tie said...

"The traditional way in which to curb inflation is to increase interest rates; this discourages borrowing and thus decreases the increase of the money supply."

Right now, the money supply in the US is just about to decrease, and this is a harbinger of deflation (now showing up in asset prices). Fractional reserve banking works in reverse: all those written down bad loans.

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/07/11/cnmoney111.xml

Kay Tie said...

"The traditional way in which to curb inflation is to increase interest rates; this discourages borrowing and thus decreases the increase of the money supply."

Right now, the money supply in the US is just about to decrease, and this is a harbinger of deflation (now showing up in asset prices). Fractional reserve banking works in reverse: all those written down bad loans.

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/07/11/cnmoney111.xml

Kit said...

I would disagree with Matthew Sinclair. As Milton Friedman said "Inflation is always and everywhere a monetary phenomenon."
The commodity boom is a symptom not the cause.
We have had a government induced supply shock in oil and food but supply shocks are only transitory - painful but not long lasting.

the a&e charge nurse said...

"Financial markets are moved by contagion and hysteria. New communication technologies magnify SUGGESTION. Mesmer & Charcot and better guides to the new economy than Heyeck or Keynes" .

"............the internet confirms what has long been known - the world is ruled by the power of suggestion.

[Gray - Straw Dogs, p171].

the a&e charge nurse said...

quote should read ......... ARE better guides.

Devil's Kitchen said...

A&E,

Pretty much what I mean by "confidence". In order to depress a company's stock, simply start a rumour that their results are going to be shit...

Hysteria simply emphasises a lack of confidence, etc.

DK

fewqwer said...

I fail to see how fractional reserve banking can produce a never-ending increase in the money supply, unless the reserve fraction were to dwindle away to nothing.

My default position is that State interference of any kind is almost certainly a bad thing.

Mark Wadsworth said...

DK, this summary looks fair enough, but you overlook three things:

1. There shouldn't be a BoE official interest rate any more than there should be an official sterling-to-Euro or sterling-to-dollar exchange rate*. The BoE should charge as much as it can get away with and pay as little as possible.

*Which Thatcher heroically scrapped right at the start, ten years later we tried the ERM and that went tits up.

2. Eddie George admitted last year that the whole Nulabour economic miracle was a scam - they were bribing people with their own money (via runaway house price inflation**) (Hat tip, Jock Coats)

** Argument Number 1 for having land value tax - keep house prices low and stable and prevent politicians from pulling this sort of scam, the fall-out of which we are now seeing.

3. That Daily Mash article is a rip-off of The Onion's article of six years ago.

TheFatBigot said...

It is important to distinguish between two different meanings of "inflation", one general and one specific.

The general meaning relates to inflation in the economy as a whole. The totality of prices paid cannot go up if there is no extra money. It is in this respect that inflation is necessarily limited by the money supply.

In this context inflation is primarily concerned with maintaining the value of the currency against other currencies. Therefore the money supply can increase in line with real growth in wealth because each pound remains exactly as valuable in real terms as it was before. An increase in money supply without an increase in wealth reduces the real value of each pound resulting in Johnny Foreigner wanting more pounds for each of his greasy groats.

The specific meaning is what is generally referred to as inflation - changes in the prices we have to pay for the things we need every day.

You can keep the money supply stable and thereby prevent systemic inflation but that is no consolation to Mrs Miggins when she pops into Mr Patel's Merry Mart to do the weekly shop and finds her staple diet of foie gras flavoured potato crisps has doubled in price.

The cost of Mrs Miggins' life is limited by the amount of money in circulation in her purse. An increase in the unit price of foie gras crisps must be compensated for by either the consumption of fewer packets thereof or gassing the cat to save on pet food. Either course has the same effect on her economy - she still has the same income but can now buy less with it so her standard of living is reduced. Within her little mini-economy the real value of the pound has fallen even if it has not fallen in the economy as a whole.

Increased wages are inflationary in the specific sense of the term when they result in higher prices for, in the present example, foie gras flavoured potato crisps.

They are inflationary in the general sense of the term only when they lead to the government pumping more money into the system to allow Mrs Miggins the extra cash she needs to buy both crisps and pet food.

Roger Thornhill said...

Doesn't the BoE rate tie in to the rate the Primary Market gets for Gilts?

The BoE needs to somehow regain control of FRB so that the amount of loans outstanding at any one time is under their control without the BoE ending up "owning" the debt that would occur if it used traditional instruments, e.g. banks sold the BoE Bonds in exchange for (BoE created fiat) balances they can lend on and that must be repaid - this would mean the BoE would end up being the final, ultimate owner of all debt. That to me sounds a bad thing.

CityUnslicker said...

Pretty darn good Devil.

Domestic interest rates are pretty useless faced with a global commodity boom.

Ah well. Your point re government spending and BOE independence is well made.

One reason not to agree with Cameron re an independent spending group. The point of government is to raise and spend the money. To dole it out elsewhere is nonsense and allows politico's to shrug shoulders and point at someone else when they screw up.

Sam said...

DK

It's imperative to separate the concepts of general price inflation from the price increase of a certain thing (eg oil). ie if more money is spent on one thing then it cannot be spent on another. The blame for general inflation therefore must lie with an increase in the overall money supply.

Therefore, while govt borrowing is despicable, it is not necessarily inflationary if they tax us the same amount (ie if there is no extra money created and it's just spent on different things).

The current credit crunch (and indeed every recession) is caused by all those chickens coming home to roost from the poor investments made during the boom when the only reason they looked good then was because money was so cheap (banks couldn't give it away!).

Consumer price inflation may have been around 2% pa over the last decade or so, but the money supply was still increasing by over 10% pa. The effects of this can be seen in the increased prices of house and equities for example. These chickens are now coming home to roost. CPI has been relatively low because of (among other things) cheap Chinese imports in those particular goods included in the CPI "basket". Other goods not included in the basket were increasing faster (so on average by over 10% pa). Never trust a govt statistic!

Hope this helps.

Sam

Hugo said...

Fractional-reserve banking can only cause a bit of inflation, and it can only cause it once.

Say there is £100 in circulation. The banks can make this effectively about £500 through fractional-reserve banking. But then they can't increase the money supply any more.

The only thing that can cause long-term inflation of a currency is printing more of that currency. Since our currency is government controlled, inflation is only caused by the government.


The Bank of England shouldn't be independent. It should be abolished. The government should not interfere in the market for credit. They should not be lending. The market interest rate should be free of government influence.

Maybe keep the Royal Mint to print the money. But abolish legal tender laws - people should be free to use any currency they want.