Alasdair Macleod – 31 March 2010
The UK’s economic outlook is clarifying, so long as you are not a blind optimist. One reason it has clarified is the Conservatives have announced their unconditional determination to impose an extra tax on the banks. In this one statement they have confirmed our fears: they do not understand the causes and nature of the financial and economic crisis: they are shooting the messenger, and if they do not understand this, they have no remedy for our ills. This was confirmed last Monday night when Osborne went head-to-head with Darling and Cable and hardly criticised the economics of socialism beloved by the other two. He was the third socialist on the platform.
It was unlikely perhaps, that Osborne and Cameron truly understand the fallacies of Keynesianism and monetarism, which is required knowledge if they are to have any chance of steering Britain out of its mess. Cameron is not a Thatcher and he has not studied Hayek. He does not have Keith Joseph or Alan Walters. Furthermore, this time the problem is at least one whole dimension larger. The truth is that all credit bubbles end in a crisis, and the last credit bubble is the largest recorded in history.
It is also irrelevant who wins the election, because the outlook for inflation is now settled. It is now a certainty that hyperinflation for sterling is unavoidable (if it was not already), which should therefore be incorporated in any credible economic forecast. No one is doing this yet, so presumably no one knows where to start. The precedent of the Weimar Republic teaches us that the effect of monetary inflation on prices is not a laboratory constant, but is decided by human reactions and anticipations. A distinction has to be made between assets and goods, which can be expected to behave differently, Many services will probably disappear. The future is complicated by all other major governments also having to rely on monetary inflation for finance. The price effect of these inflations will be reflected in fiat currency rates, and while they may all end up being relatively worthless, there is the potential for wide variations in individual currency rates on the way down.
There are many variables and uncertainties involved, so what follows should be read with this in mind. The intention is to illustrate rather than firmly predict. It will simplify the analysis to break it down into four distinct phases.
This describes the current situation. There are few concerns over inflation, which is commonly believed to be a problem only in the event of economic recovery. The greater priority is to secure economic growth, to ensure there is enough money and credit available for the private sector, and to maintain budget deficits. However, given the unprecedented scale of the stimulus so far, the results have been disappointing, with extra debt and money creation having little positive effect. There are pressures now building to reduce deficits; pressures likely to undermine economic performance.
There are also concerns being expressed by some market-oriented commentators about the large amount of debt to be funded by all governments, so it is no surprise that the weaker borrowers, such as Greece and Portugal, are running into difficulties. These funding difficulties can be expected to spread to other countries, notably the UK and the US.
The UK is the more exposed of these two, since there is little reason for an international investor to hold sterling. While the Bank of England printed enough money to fund the entire budget deficit last year without outside help, gilt yields have been kept low. But the opinions of holders of sterling matter, and they have begun to sell the currency down from recent highs of over $1.60. A general fall in the currency over the last year has raised prices of key consumer items, particularly energy. Petrol at the pump is now £1.20 per litre, having last been at this level when oil was $145 a barrel, and the CPI annual rate has risen 3% in the year to February, having been only up 1.1% last September.
A lower currency usually feeds through to higher prices, but the initial effect when consumers are not spending is to squeeze margins. By this process excess capacity is eliminated, but thanks to government initiatives, such as the scrappage scheme, the process has only been delayed. Since the banks are aware of this excess capacity they are reluctant to lend, squeezing medium and smaller sized businesses that do not have access to other sources of finance. It is these companies that are the main employers in any economy, so employees are insecure while they are encumbered with record levels of debt. Until the problem of excess capacity is addressed the economy goes nowhere except eventual collapse. But government resists the process of allowing capacity to reduce, because of the consequences for unemployment.
The reluctance of banks to lend is reflected in a contraction of bank lending, contrasting with the rapid growth of narrow money instigated by the Bank of England. While ignoring the expansion of narrow money, economists are more concerned at the deflationary implications of the broader measure. Meanwhile, negligible interest rates have fuelled the stock market rally and steadied residential property prices. The performance of these asset classes has done much to maintain confidence.
Phase 2 will commence with a crisis, whose principal elements will be a rapidly deteriorating outlook, a renewed fall in sterling and a steeply rising cost of government funding. It is this combination that is the government’s worst nightmare, but the failure of their Keynesian and monetarist remedies are already becoming apparent. The markets will discount these dangers, perhaps enshrined in a ratings downgrade for sterling. With its track record of profligacy and the competition for a share of the international savings pool, Britain is poorly placed.
This convergence of events for Britain could not be worse. Politicians will naturally believe in more quantitative easing to counter the slump, while the markets will demand the opposite. The result will be a fall in the currency and sharply higher gilt yields, with the government being dragged into action rather than staying on top of markets. Internationally, other countries will be suffering similar problems, for the problems afflicting the UK are common to all other countries with high levels of government and private sector debt. The UK is bad egg in a bad clutch.
Britain’s trading partners are similarly past their sell-by date, and the EU has the added complication of uncertainty over the durability of the euro. The hope that lower sterling will boost exports into her largest trading partner will therefore be largely unfulfilled. Meanwhile, the UK’s other major trading partner, the US, has placed herself in at least as bad a position as the UK, and even though the dollar might find support from portfolio flows, the crisis there will be at least as acute.
So Phase Two will rapidly develop into the eradication of surplus capacity in the UK, US and Europe. But this is not just the obvious over-capacity; it will also involve the elimination of many of the businesses that thrived in the pre-credit crunch environment, when consumers happily bought non-essentials on credit. Services will probably contract faster than goods, since this sector is substantially ephemeral.
The elimination of surplus and unnecessary capacity will inevitably be accompanied by lower prices while businesses try to survive. Knowledge that prices are falling will further deter consumption, speeding up the process. There will be a short period of severe price deflation as goods and assets struggle to find a clearing level. It is during this process that we can expect the supply of narrow money to escalate again, with central bankers justifying their actions in the name of price stability. The Fed and the Bank of England could easily more than double the monetary base to stave off the perceived evils of deflation. However, only when this capacity has been eliminated will the supply of goods stabilise, and the consequences of monetary inflation begin to feed through to prices.
Asset prices are driven differently from those of goods and services, because they are primarily dependant on interest rates, the level of leverage in the asset class and anticipated cash flows. They will fall and contribute to the slump as gilt yields rise, both by the emergence of forced sellers and by reducing the value of collateral for those not immediately forced to liquidate. Commercial banks will suffer substantial losses from collapsing collateral values and write-offs and in turn will be bankrupted.
Governments will be required to keep commercial banks afloat, not only for political reasons, but also so that the bank accounts exist to facilitate the transfer of money. Furthermore, if the commercial banks are allowed to fail, the investment banks would certainly follow as the $600+ trillion OTC derivatives markets fall apart.
At the international level governments will probably seek to co-ordinate an accelerated rate of monetary inflation. The stated objective will be to manage the crisis and reduce currency volatility, which can be achieved through central bank intervention. A truer definition of the objective will be to control prices and interest rates.
Those countries which might have adopted sound money policies will fall into line, rather than endure the penalties of a strong currency against the dollar, thereby importing monetary inflation from the profligate.
The emergence from this period of price and asset deflation sets us up for Phase 3.
Phase 3 starts with excess capacity substantially removed from the economy, unemployment at record levels, and the government’s insolvency barely concealed. It is these conditions that lead to monetary inflation being more directly reflected in rising prices for goods, rises which are no longer masked by excess supply. By now prices will have some catching up to do, impelled by new supply constraints resulting from loss of capacity. Nominal interest rates will be rising strongly to keep pace with accelerating inflation, and the government will be unable to fund its enormous and growing deficit without printing yet more money at an accelerating rate.
So far, the Bank of England will have been printing money as a response to the 2007 banking crisis, to rescue the economy from deflation, and now to keep pace with inflation itself. Even consumers will at last understand that paper money is loosing value on a daily basis because it is being printed. This period is brief, marks the turning point for asset prices, and leads us into Phase 4.
Phase 4 is the inflationary blow-off, and in Germany in 1923 was characterised by a shortage of money, because prices began to increase faster than the supply of money. In their transactions people not only factored in monetary inflation, but anticipated inflation to come. The constraint on the supply of money was its physical production. The difference between then and now is that most transaction money is produced electronically through credit and debit cards, which is fine so long as ATMs continue to work and the surviving banks can shovel money quickly enough around the system.
The end of Phase 4 is a valueless currency.
How can this depressing conclusion be avoided? In a modern democracy it is hard to see how, because governments simply do not have a mandate to even consider imposing the necessary hardship on its electors. The only solution to our economic problems is to unwind all the economic distortions since Keynes; to deregulate and substantially rescind laws that control the market’s behaviour and to return to the caveat emptor of free markets. It involves reducing government to a small cog in the economy, deaf to all pleas from businesses and individuals to intervene in their business. All this does not have to be done at once, but the direction of policy must be definite. What are the chances? None. In common with other countries the UK is now firmly locked into the contradiction of squeezing the private sector in order to support it. Since governments are powerless, the solution will be forced upon us by markets.
At the heart of the inflationary commitment is the impossibility of escaping from it, and when the primary function of a central bank is to print money as the economic panacea, inflation has passed the point of no return. For that reason, a progression through the four phases of inflation described above is the likely outcome.