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Sunday, 26 April 2009

The crash that is yet to come

If you think it is bad now, you haven’t seen anything yet. I am not an out and out pessimist, nor even a pessimist hiding under the cloak of “realism”, but I do believe that if something is too good to be true, then it probably won’t last. Markets. like water flowing under gravity flow inexorably to an equilibrium point.

For many years I have been involved in what might loosely be called industrial finance, or more precisely financing the factories, power stations, communication systems and modes of transport that make our daily lives. For as long as anyone alive can remember those industries, were the bedrock of our prosperity, and it was because of that prosperity that we in the first world have been able to live a lifestyle far in advance of the rest of the world.

That prosperity spawned a host of service businesses and well paid professions that in turn were able to pay for ever more sophisticated products, and at the same time to spawn a welfare state and system that grew and grew. The initial laudable effect of that welfare state was to relieve the causes of poverty, but as it has grown in size relative to the economy, it exists not only to relieve poverty but also now to provide a viable economic existence to many who have never and will never take part in the economy.

At the same time the connection between industry and prosperity has been broken, with much industry transferred to Asian countries, and the west making what they thought was a more valuable living from services and research and development, laudable but largely hollowing out the productive economy. Rather than respond to the pressures of globalisation which effectively undercut western production (an Anglo-Dutch steel rolling mill will find it hard to compete with a Middle Eastern mill powered at Abu Dhabi energy prices and staffed with Bangladeshi labour), western countries continued to spend as though their technological supremacy was impregnable, which it clearly wasn’t. Governments and banks deluded themselves over the west’s loss of competitive advantage and encourage the growth of personal and government indebtedness think that economies would continue to grow.

They were sadly deluded, and the consequences are becoming more evident every day. It is not the failure of banks, whose recapitalisations can be measured in tens of billions, but the annual budget deficits of large countries which run to hundreds of billions, which should cause the most concern. In the case of the UK, this will probably run to at least £1 trillion over the next 5 years.

And the problem is that the cash to fund their spending may not be there. China, Venezuela and Russia, whose economies have both contracted, have reduced the amount of overseas investment they are making, preferring to divert their funding to domestic uses. Only Middle Eastern oil states remain net outward investors, but they can cerry pick the whole world. This is going to cause considerable problems for European countries. The ones with the biggest problems will be the heavily indebted Euro countries who can’t print more money at the whim of the government, and Eastern European countries who borrowed in foreign currencies. The other country that has a serious problem is the UK, which spends £4 for every £3 it collects in taxes. There are rumours in the bond markets, that some government bond auctions are only succeeding because the government has patsies that sweep up any excess. No doubt the UK government’s ownership of Lloyds and RBS may help them as they try to borrow £200 billion every year for the next 5 years.

The National Institute for Economic and Social Research (NIESR) said last week that since UK debt topped 200% of GDP after the Second World War, so we can manage the debt-load in this debacle (80% to 100%). Not so. After the Second World War, every country had similar problems and the UK still had many competitive advantages over the third world in terms of education and technology, which have largely disappeared.

Moreover, the 80%-100% indebted ness is a vast understatement of the indebtedness of the country because it only includes the direct debt obligations of the government. The pension liabilities for civil servants are not included in that figure on the basis that the government does not know how much and when each pension will cost. This is a poor excuse. What is certain is that there are liabilities and many of them, and any actuary can come up with a figure for the present value of those liabilities. Actuaries do it all the time to determine whether pension funds are fully funded. Some would say the current figure for government liabilities for public sector pensions is over £ 1 trillion. The United States federal pension fund invests in treasuries issued by the government. No cash need change hands until redemption, but the net result is that a fair value of the liabil;ity shows up in the US National Debt.

This UK government’s argument for the non-inclusion is a poor and is similar to arguments for the non-inclusion of National Rail’s government backed borrowings and the value of liabilities under the banks’ asset insurance schemes. If the bank pays good money for insurance under a scheme where the banks is taking a first loss on the assets, it is a good bet that it expects to get wiped out on its first loss (because otherwise there would be no point in taking out the second loss insurance). So we can conclude that it is a reasonable presumption that UK bank losses are understated because they haven’t written down their losses by anything like the guaranteed amounts. Moreover, if the bank feels sufficiently adequately protected that it doesn’t have to write down the value of the assets beyond the first loss position, then it seems in appropriate that the government does not show any for those guarantees, although it will be quite happy to book the premium received as income.

So my guess is that the market for UK government debt will collapse in 2009 and that as a result this government or the next will have to annual cut government spending by the amount of the deficit, say 12% of GDP or 25% of government spending, so figure at least another 2 years of decline in GDP.

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