Sunday, 29 May 2011

Vampire City

I was asked some time ago to write a blog explaining how government debt works, who owns it and who pays interest on it.  Well, better folk than me have written on this subject, and I've listed a few of their contributions below.  But the more I look the relationship between the financial sector, the Government and ordinary people, the more I am struck by the way in which the financial sector acts like a sponge, draining real money from the economy and replacing it with debt.  Or perhaps more like a parasite, some kind of giant leech sucking the lifeblood out of Western economies. 

There are two ways in which this happens.  The first was the subject of one of my previous posts, The Great Savings Fallacy.  In this I argue that when people save by placing their money in pensions, long-term savings accounts or bank deposit accounts, most of this money is removed from the economy and is not available for investment. Additionally, much of this money is eligible for tax relief, so there is a net loss of tax income arising directly from savings. So if people follow government's advice and save instead of spending, tax income reduces and the economy shrinks. It's madness. Why does government want them to do this?

The government believes that a strong and vibrant financial sector benefits the UK economy, and therefore wants people to provide funds in the form of savings to financial institutions. Why? Will the loss of tax revenues and investment opportunities be offset by tax revenues from the financial sector and deferred spending and taxation when savers receive their pensions and draw out their money?  I don't think so.

First, let's consider the matter of deferred spending and taxation. Deferred benefits are undermined by inflation, so the value of deferred spending and tax receipts should be discounted by the anticipated inflation rate over the period of the investment.  RPI for the year to April 2010 was 4.6% and ten-year returns on pensions currently around 5.2%.  Pathetic, frankly.  Admittedly, the government's RPI target is quite a bit lower, at 2%, so a more optimistic view could discount at maybe 3%.  So real pension returns might be around 2%. Hardly spectacular, is it?  Evidently, the up-front cost in terms of loss of tax income and investment opportunity won't be recovered by this route. 

Will economic benefit therefore arise solely from taxation receipts from the financial sector? Well, the financial sector employs a lot of people and pays some of them very highly, so the Government clearly benefits from income and NI receipts from these people. Additionally, financial institutions pay corporation tax at the large company rate, and as financial transactions are exempt from VAT they are unable to recover VAT on, for example, purchases of fixed assets. But the real tax income received from these institutions is much less than might be expected.  Much has been made of the low tax rate paid by companies such as Barclays when writing down losses.  But a much bigger issue, which has been extensively written about by Richard Murphy and Nicholas Shaxson among others, is the "hiding" of company profits in offshore jurisdictions to avoid tax.  The headline corporation tax that these companies pay might be 24%.  But if they manage to hide large amounts of their profits in low-tax jurisdictions, the actual rate paid on their total profits is much less. There is some evidence that reducing the corporation tax rate reduces the incentive for large companies to pay accountants to find clever ways of avoiding tax, and reducing corporation tax rates can attract businesses to set up in the UK. Hence the Government's strategy of reducing corporation taxes and offering tax breaks to companies. Some tax is better than no tax, it would seem.

But the opportunity cost of loss of savings from the economy is HUGE - much larger than any potential gain from taxation in the financial sector. Clearly taxation alone is not sufficient to explain the government's belief that savings are essential.  The government, like many people, confuses savings with investment - in fact the terms are used interchangeably.  Now, if savings were actually used to finance investment in the UK economy, this confusion would be immaterial.  But the fact is that savings do not finance investment in the UK economy.  They are traded on the international financial markets, where they simply change from one type of paper money to another without ever being used to finance the production of real goods and services.  A small amount of the profits generated through this money transformation process does go back to the saver in the form of interest, which is eventually taxable.  But the vast majority of those profits go to line the pockets of pension and hedge fund managers. Meanwhile the UK government has to borrow to finance investment programmes.  Who does it borrow from?

When the UK government borrows, it issues government debt securities - known as gilts because the pieces of paper that represent this debt are traditionally edged with gold, or "gilt-edged".  Gilts are traded on the international capital markets, where they are regarded as a virtually risk-free form of saving.  Financial investors looking for a safe place to put their money buy up gilts.  The heaviest purchasers of gilts are pension funds, followed - since the financial crash - by banks. So the people of the UK do indirectly lend to the government  through their pension savings and their investment in UK banks. However, only new issues of government debt actually finance investment. Purchases and sales of gilts on secondary financial markets - which is the way in which gilts are most frequently traded - only benefit traders.

So pension savings, unless they are invested in new debt issues which are held to maturity, don't benefit the UK economy.  What's more, the government actually pays much of the return on pension savings.  It works like this.  People put their savings in pension funds and other such vehicles, which use that money to buy gilts together with private sector securities such as corporate bonds and equities (including bonds and shares issued by banks). The government pays interest on gilts, which provides a small return to the pension saver and a much larger one to pension fund managers....but hang on.  That pension saver is presumably also paying income tax and NI, which the government uses to pay the interest on the government bonds. As an example, yield on ten-year gilts is currently about 3.5% - not great, but certainly better than the average return on a pension investment (note the yield calculation takes the time value of money into account, so there's no need to discount the rate). The pension saver pays no income tax or NI on money invested in pensions.  But because of the difference between the interest rate on gilts (which is in effect paid by the pension saver through the tax on the rest of their income) and the long-term return on pension investments, the pension saver is in effect paying a small amount of tax on the portion of their savings that is invested in gilts - which may be most of the investment (see example here).  The return on those savings is therefore only the difference between the income tax and NI foregone and the notional tax paid. The pension fund might as well have invested in moon cheese.  The saver would have done better to make no pension provision at all, pay tax and NI on ALL their income and spend the remaining money on goods and services that benefit the economy. And the government, overall, has LOST tax income.  The only people who have benefited are the pension fund managers.  In effect, money has been drawn out of people's pockets and into the City. Some comes back as taxation and consumer spending, of course, but most of it is reinvested on the international financial markets or stashed away in Jersey, Isle of Man, Cayman, Switzerland, Bermuda.....

Have I made sense so far? Pour yourself a stiff drink. The worst is yet to come.

Here's the second way in which the financial sector sucks money from the economy. To explain this I need to talk about the way in which fractional reserve banking creates new money.

When a bank lends to a customer, it doesn't have to have physically available the money it is lending at the time the loan is granted.  It only has to have physical funds for settlement when the loan is drawn down, and it can of course borrow these funds from other banks. Readers of my blog The foundation of short selling will recognise this as a short selling strategy - you sell something you don't physically have and cover settlement by borrowing.  Bank lending in the 21st century is the largest short selling scheme in the world.

When a bank loan is sold short and not physically settled, the accounting entries for it create new money.  This is because banks lend using deposits as collateral.  When a loan account is created, the bank also creates a matching deposit for the amount of the loan - usually by making an electronic entry for the amount of the loan in the customer's current account. This entry enables the customer to draw down the loan.  However, the bank then uses this deposit (which it has created by lending, not by actually receiving a customer deposit) as collateral against other lending.  The effect is that the amount of "money" in the economy as a whole is inflated.  The problem, as I'm sure you have realised, is that this money is not real.  It is not the product of real economic activity but a consequence of the way in which bank loans are recorded. When the bank loan is paid back, the deposit disappears as well and the economy shrinks by the amount of the loan.

So how does this activity suck money out of the economy? The problem, of course, is the physical settlement of loans. The idea behind bank lending was originallly that banks accepted real customer deposits and lent that money out in the form of bank loans - this is known as financial intermediation. But when banks create loans out of thin air ("credit creation") those loans have to be funded too, even though the banks don't have  real deposits to support them. As long as banks can borrow from each other, and especially from the investment banking sector, which tends to be savings-rich, there is no problem funding these loans.  This, of course, is the real reason why government is so keen for people to save. Investment banks, pension funds and other such financial institutions need a good supply of funds, because they provide liquidity to the interbank lending markets. Highly liquid interbank lending markets are essential to support bank lending.

But if the interbank lending markets dry up, banks turn to central banks for support - i.e. to government. This is what happened after the failure of Lehmann Brothers in 2008. The banks stopped lending to each other and instead tapped central bank reserves for funds. These funds were (and still are)  provided by taxpayers.  Billions of pounds, dollars and euros were pumped into the banks to support their loan settlements.  The banks are not able to pay this money back because the money never existed in the first place.  The deposits they used as collateral weren't real.  But the money provided to them by taxpayers was real money, generated by tax income from real economic activity. So the banks have sucked real money out of the economy and replaced it with huge amounts of sovereign debt.  All major Western economies now have debt problems as a result of the massive collapse of bank lending in the last four years.  In effect, the imaginary deposits have now been replaced with real ones by government, leaving government with debt.

Now, just to recap - who buys government debt? Financial institutions do....pension funds, hedge funds and banks. Yes, that's right - banks. The government borrows from banks in order to replace the (real) money they provide to banks to replace the (imaginary) money that banks create through bank lending.  The more money banks lend, the more goverment has to provide to support them and the more it therefore has to borrow from them. At present the government is actively encouraging banks to buy gilts so that they have a buffer of risk-free liquid assets that they can use to fund depositors' withdrawals without having to tap central bank reserves.   But the government pays interest on the money it borrows from banks.  So taxpayers pay interest to banks both directly on bank loans and indirectly through their taxes.

And the final straw is.....too much government debt, and financial institutions start to get worried. Well, any sensible parasite would be concerned if its host looked a bit worn. After all, the survival of the parasite depends on a healthy host.  So supra-government institutions such as the IMF, whose sole purpose is to ensure the survival of the international financial system, insist that governments inflict austerity measures on their citizens to reduce government debt levels.  Debt levels that are sky-high not because governments have overspent, but because banks have conjured into existence far more money than has been produced through real economic activity and have then dumped that difference on government.  And governments so far have preferred to cut the wages, benefits and living standards of their own people to the bone rather than face down the financial institutions who have sucked them dry.

Welcome to Vampire City.

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Further reading:
Pub Philosopher:           State debt - a giant PFI scheme                
Sturdyblog:                   To whom do we owe this money, exactly? 
                                    THE ANSWER (To whom do we owe this money, exactly?)
Stumbling & Mumbling: Against the rally against debt

Saturday, 14 May 2011

Modern gods and human sacrifice

I read a fascinating post today by the excellent Australian blogger billy blog. In it he notes that even when the Australian government was running surpluses between 1996-2007, the international financial institutions pressured it to continue issuing debt - and it gave in to them. During that period the Australian government issued more debt than it needed but didn't actually use the proceeds in any way that benefited the people of Australia.  This intrigued me. Surely when a government is running a fiscal surplus it will pay off debt, won't it?  Well, apparently not.  Why not?

Billy answers his own question at length in the blog, but to summarise here - the government continued to issue debt because the international financial markets needed it for liquidity.  It had nothing to do with the people of Australia and everything to do with providing risk-free funds to speculators.  And the taxpayers of Australia paid interest on that unnecessary debt.

At the same time as the international markets were calling for more Australian risk-free government debt, they were also shouting about the need for welfare reform and spending cuts. And the Australian government gave in to them on that one too. At the same time as it was issuing unnecessary debt and running a fiscal surplus, it cut welfare spending programmes to the poorest in society.

Now why on earth would a democratically-elected government ignore the wants and needs of its electorate and dance to the tune of the international financial markets?

Well, it's all about the power of the big international financial institutions, and in particular the credit rating agencies, the IMF and the World Bank.  Governments are terrified of them, and with good reason.  Recently we have seen downgrading of credit ratings for various countries in the European Union. The consequence of this is that these countries are now paying far higher interest rates on their debt, at ruinous cost to their citizens. However, Portugal - feistier than the others - is fighting back. It has commenced an international criminal inquiry against the three main international credit rating agencies (Moody's, Standard & Poor and Fitch) on the grounds that when these agencies downgraded Portugal's debt they CAUSED the sovereign debt crisis that forced Portugal to seek assistance from other EU members. Portugal suggests that these agencies may have benefited financially from the country's ensuing difficulties and claims that these agencies wield excessive power due to lack of competition.  Portugal was unable to service its debt and was bailed out by the ECB on condition that they imposed austerity measures on their citizens - which so far the citizens have refused to accept. They should be thankful. In Greece the IMF is involved and the imposed austerity measures are far more severe. And in Africa, where the principal agent has been the World Bank, the austerity measures imposed on countries that have suffered from capital drain have caused famine and wars.  No wonder governments are scared.

I'm not going to discuss here whether the behaviour of the credit rating agencies actually causes debt problems or is simply a response to the prospect of debt difficulties. The point is that the effect of debt downgrade is high interest rates and loss of international reputation - and above all, unhealthy interest from some international agencies (the IMF and World Bank, in particular) that have a terrifying reputation. No government wants the IMF hovering around, and to avoid this governments will adopt all manner of measures that hurt their citizens. The IMF and its lackeys, the credit rating agencies, are particularly attracted to countries whose expenditure persistently exceeds their income - even if these countries are meeting their debt obligations without difficulty.  Running a deficit for any length of time is a dangerous strategy, and the UK has run one for quite some time.  No wonder the Coalition government is so hysterical about "getting the deficit under control".  They are fobbing off the international sharks.

I commented in a previous post that there is a fair degree of confusion over whether the Coalition's aim is to reduce the deficit or the debt. In my view it is neither. They are placating the international credit rating agencies and by extension the IMF.

As far as the deficit is concerned, the aim is not to reduce the deficit but to hide it.  The easiest way of hiding a deficit is to shift the difference between expenditure and income to private individuals. They can go deeper into debt, go bankrupt, lose their homes or starve to death without affecting a country's credit rating or attracting IMF attention - as is evident in India's economy, for example. A programme of spending cuts aimed at low to middle income earners reduces the deficit quite nicely and has the additional effect of creating public unrest, which helps to convince the rating agencies that the Government is really doing something. It's all spin and doesn't fix anything. But it hurts lots of people.

Now the effect of hiding the deficit should be, of course, that government debt stops growing. But this is a bit more tricky. Because, you see, the same institutions that want spending cuts to reduce deficits also want governments to issue debt. You might think this is an extraordinary example of doublethink on the part of the international institutions, but it isn't really. Government debt is only useful to financial institutions if it is low-risk. Countries that run deficits are riskier than those that don't, so the safest debt is of course that issued by countries that don't run deficits - and they want lots of that debt, whether or not the country itself needs it.  To these institutions, the issuance of public debt has nothing whatsoever to do with deficit financing or public investment: its sole purpose is to ensure a plentiful supply of highly liquid, virtually risk-free funds for international speculation.  So the international institutions apply immense coercive pressure to governments to reduce or eliminate deficits, thus reducing risk, while maintaining debt issues, thus ensuring liquidity in the international financial markets. Hence the Australian government's bizarre behaviour. 

There is nothing logical or rational about spending cuts to reduce a deficit when a country is comfortably meeting its debt obligations and is experiencing an economic downturn - which is the situation in the UK at the moment.  There is also nothing logical or rational about governments continuing to issue debt and cut spending while running a fiscal surplus, as the Australian government did. It's all about placating the gods.

In days gone by, people believed that there were powerful, moody and unpredictable gods. If an individual angered the gods, he (or his descendents) would suffer a terrible fate. The essence of classical tragedy is retribution for hubris, which is the "sin" of challenging a god's supremacy.  When the individual challenging the god was a king or ruler, retribution could be enacted against the people he ruled. And humans didn't have to do much to anger the gods. Orpheus angered Apollo simply because he could play the lyre beautifully and Apollo was jealous of his skill.  But above all, humans who disobeyed gods came in for terrible punishment. The Old Testament is full of stories about disobedience followed by punishment.

We like to think that we have moved on from all this superstitious nonsense. But we are the same people, really, and have the same mindset. Only now the deities we worship are not weather gods - they are unelected and undemocratic international institutions that wield excessive power, have their own agenda and care not a jot about ordinary human beings. Anger the credit rating agencies, they downgrade your debt. Anger the IMF, it withdraws "essential" funding (although I question whether that funding is either necessary or theirs to give).  And these "deities" are greedy and rapacious. To placate them, governments drain their countries' resources and sacrifice the people who elected them, or more often, those that didn't.

But these "deities" don't have to have this power. They only have this power because we give it to them.  We don't have to do what they say.  Governments don't have to issue debt they don't need. They don't have to inflict unnecessary spending cuts on their people. All that is needed is for governments to take back their power from these self-appointed demigods. 

Democratically-elected governments are sovereign in their own countries. They have the right and the power to issue their own money, obtain funds through taxation from their better-off citizens and businesses, borrow from these as well if they wish, and spend this money as they see fit to benefit the people of the country. If a democratically-elected government wishes to run a deficit, it can fund that by creating its own money or borrowing from its citizens. It doesn't need to borrow from international financial institutions, and it is time that these institutions recognised that they have no right to insist that governments provide them with risk-free funds. No international institution should coerce a democratically-elected government into taking actions that hurt its citizens, and no democratically-elected government should allow international institutions to dicate how it should run its economy.  And above all, democratic governments should support each other in standing up to the demands of the international institutions. Let governments work for people, not for the international financial system.

Wednesday, 11 May 2011

Open Letter to Mark Reckless, my local MP

Dear Mark

I am writing to support today’s Hardest Hit march.

The package of cuts being enacted by the Coalition affect housing, disability, sickness and welfare reform. In short this means that many of the most vulnerable members of our society are being targeted. Disabled people have higher costs than other people because of the additional requirements they have, whether it be for a special diet, clothing or communication and interpretation needs. In this regard I would draw your attention to the report written in 2004, entitled 'Disabled People's Cost of Living', which highlighted the fact that:

"The weekly income of disabled people who are solely dependent on benefits is approximately £200 below the amount required for them to ensure an acceptable, equitable quality of life. Unmet weekly costs for disabled people who work 20 hours per week at the minimum wage are up to £189 (for those with high-medium needs."

Yet despite the daily struggle faced by the disabled community they are now facing huge cuts to Disability Living Allowance, Housing Benefits and other equally important forms of help that they need to get by.

Most economists say that the deficit reduction package is too hard, too fast. Indeed in the ten largest consolidations of debt since the late 1970s (and Britain would count among
them), the average pace of deficit cutting was 1.9% a year. Based on that estimate we would take 6 years to eliminate our deficit. Yet these other examples of deficit cutting countries have cut during better economic times, rendering the comparisons with countries like Canada and Sweden mute. Robert Skidelsky of the Financial Times wrote:

“This will extract 5 per cent out of a shrunken economy. It is the most audacious axecutting exercise in almost a century, double the size of the cuts in the 1930s, equalled only by the 1921 Geddes Axe, which cut government spending by 11 per cent in two years.”

However an economic/political decision has been made, irrelevent of who agrees. My question to you is, if you think these rapid cuts are necessary, why do they have to be targeted at the worst off in society?

Cuts in housing benefit will mean a third of England will become unaffordable for low-income households within a decade. Crisis have recently published a national survey saying that the cuts could put an additional 88,000 people into homelessness!

Despite a fraud rate of just 1 per cent, 500,000 people who currently rely on sickness benefits are being targeted. Parts of the media have been harrassing the disabled community for a long time, labelling all as 'benefit scroungers'. But what is the Government doing to counter these perceptions?

Cutting disability benefits and removing key services that the disabled community use will result in life becoming much tougher for thousands of families with vulnerable relatives. Disabled people, their friends and families have a lot to fear. And it is driving many to despair. Already there have been suicides. Up to 10,000 people are expected to march today, and many thousands more want to go but simply aren't able, which must I believe highlight the widespread nature of our concerns.

I, as well as many others, am opposing these cuts today because I care about the old, the sick, the disabled, the vulnerable and the needy. I would appreciate it if you could reflect on what I have written and consider calling for more compassion in government.


Yours sincerely,

Frances Coppola

Monday, 9 May 2011

Illusions and delusions - the lure of credit and the price of debt

This blogpost is all about debt - national debt, personal debt, government debt - and its effect on the UK economy and the lives of the people of the UK.

We hear a lot about the "national debt" being too high and growing because we are running a deficit. There has been an astonishing degree of confusion between "debt" and "deficit" from some notable people - including the Chancellor of the Exchequer - so I thought I'd start this blogpost by explaining "debt" and "deficit" and how they relate to each other.

By "national debt" people usually mean Government debt, which is the money that the Government borrows from banks and other financial institutions to fund the difference between its spending and income.  In any one year, the difference between Government income and expenditure is either a surplus (if income exceeds expenditure) or a deficit (if expenditure exceeds income). If there is a deficit, additional money must be found to cover the excess expenditure, either by selling assets (for example by privatising state-run industries) or borrowing from banks and financial institutions. The Government has been running a deficit every year for nearly 20 years now, and has borrowed every year to cover that.  The accumulated debt over that time is known as "Government debt". Every year the Government runs a deficit and pays off no debt, the total amount of Government debt rises by the amount borrowed to cover the deficit. So debt is not the same as deficit, but deficits usually result in debt.

As with all debt, Government debt is only a problem if it is not affordable. The Government's ability to service its debt depends on its income and on the interest rate it is paying.  Government income, which is mainly from taxation, is positively related to "gross national product" (GDP), which is the monetary total of all outputs into the economy from all sources: if GDP rises, tax income rises. Increasing GDP in relation to debt also reduces the risk to the lending institutions: the lower the perceived risk, the lower the interest rate.  Conversely, as debt rises as a proportion of GDP, the perceived risk to the lending institutions rises.  Historically UK Government debt has always been regarded as a completely safe investment, so interest rates are very low - but if the proportion of debt to GDP rises too high, the lenders might change their minds about this and start to charge higher interest rates, which would have to be paid from tax income, which would increase the deficit further or require further spending cuts.  This is the primary reason for the austerity measures put in place by the present Chancellor in June 2010 and further extended in April 2011. The concern is that debt is growing at an unsustainable rate and lenders may start to raise their rates. Austerity measures are designed to reduce the rate of growth of debt in order to demonstrate to lenders and credit rating agencies that Government debt is as safe as it has always been. They have nothing whatsoever to do with reducing debt.

The best way of reducing the impact of Government debt is often to take measures to increase GDP - i.e. economic growth - because if GDP grows more than the amount of the debt the proportion of debt to GDP declines, tax incomes increase and the whole thing becomes more affordable. Stimulating economic growth is actually the current Government's strategy for reducing debt - but there is as usual disagreement over whether their measures to stimulate growth, such as cutting corporation tax and other measures to encourage business investment, are appropriate or effective. The debates are endless.

Government debt at present runs at getting on for 60% of GDP excluding financial sector intervention (source: Office of National Statistics), which for a peacetime economy is uncomfortably high and expensive to service - interest payments on this debt currently cost about £43bn per yearIt is true, as Richard Murphy and others have pointed out, that Government debt has actuallly been higher than that as a proportion of GDP for most of the last century.  It is also true that the high debt levels were mainly because of two world wars and a major depression, so shouldn't really be compared with the present situation.  To be honest the reason for the debt is irrelevant. The question is whether it is unmanageable.  Is it unmanageable at present? All the major political parties seem to think so, but many top economists disagree. The debates are endless.

As usual when there are endless debates about the best way of achieving something, something major is being ignored. In focusing on Government debt alone I believe we are missing the real issue. The true level of debt in the UK economy is MUCH higher and is completely out of control. It is ruining people's lives, destroying businesses and wrecking any prospects of a return to prosperity in the near future.  I am referring to the levels of personal debt - the amount of money that people in the UK individually owe to the banks.  

Personal debt levels are currently running at just under 100% of GDP (see Credit Action's useful if horrifying statisics on personal debt). Add this to the 60% of GDP figure represented by Government debt, and you arrive at a total debt figure for the UK economy (excluding corporate debt, which is complicated by cross-border issues) of about 160% GDP. I believe we should regard this as the true "national debt" - not Government debt alone. Now, we have paid off debts of this stature before, so it's reasonable to suppose that we could do so again. But so far we haven't even admitted it exists, so of course there are no policies for reducing it.  On the contrary, current Government policies for reducing the deficit are expected to raise personal debt levels by 20% over 5 years (source: Office for Budget Responsibility quoted in sturdyblog).  So what the Government is actually doing is cooking the books - shifting the responsibility for the deficit from the state to the individual.  Government debt will indeed grow more slowly, which will placate credit rating agencies and institutional lenders. But the total national debt level will rise nearly as fast as before.

This is madness. Government can borrow far more cheaply than individuals. The cost of servicing that debt will rise significantly as it shifts on to the shoulders of the ordinary people of this country, many of whom are already carrying debts that they can't afford. It seems that yet again, in order to keep banks and markets happy and Government borrowing costs low, we are prepared to accept vastly increased costs and higher levels of poverty for the people of the UK.

But why are people so heavily indebted? And does it really matter anyway?

The single biggest cause of the massive rise in personal debt since the second world war is the increase in home ownership. Virtually all homes in the UK are bought with a mortgage, and most people either have bought their own home or aspire to do so. Policies of successive governments have encouraged individual investment in property, including mortgage interest tax relief (now ended, but significant in the 1980s property bubble), extension of housing benefit to cover interest payments on mortgages, and most recently property finance schemes aimed at people on lower incomes, such as shared ownership and low-start mortgages.  Along with the mortgage debt usually goes other debts as well, such as home improvement loans, because people who own their own home are responsible for maintaining that property.

Obtaining a mortgage became much easier in the years leading up to the financial crisis. Mortgage lenders made loans at higher and higher income multiples - at the time of its failure Northern Rock was offering mortgages at 6 times income. They offered non-status loans, where people could obtain a mortgage without having any evidence of ability to pay. They offered mortgages of 100% or more of the property value - at least one lender offered up to 125% of purchase price, which amounts to an unhedged speculative investment in an overpriced market. Insane.

As a consequence of all this easy money and insufficient availability of property, house prices soared - a massive asset price bubble that still has not come down sufficiently.  Now we have had house price bubbles before, most notably in the 1980s when it was followed by a housing price crash in which lots of people lost their homes and lots more spent years unable to move due to negative equity (I was one of them). You'd think we would have learned from that.  But we were sold a myth that the Government had fixed "boom and bust". There wasn't going to be a crash. House prices would continue rising for ever. Cheap credit would be available for ever. You couldn't lose.

It wasn't just mortgages, either. Credit cards became so readily available that people with little or no income could obtain them without difficulty. Credit limits were unchecked and often raised without the holder's consent. Yes, you can argue that people shouldn't have spent on their credit cards. But when 0% credit cards were so easy to obtain, you could simply spend on them and move the balance from one card to another, never really paying them off. Again, you couldn't lose.

What this easy credit actually did was plug the gap between people's real wages and the prosperous property-owning lifestyle we were all encouraged to adopt.  Banks were happy - they were lending out huge amounts of money, were getting interest on it (admittedly at low rates, but they were lending so much it didn't matter) and were hugely expanding their balance sheets. People were happy - they had the money they wanted or needed, and the fact that it wasn't theirs didn't really matter because interest rates were low and if they managed things right they wouldn't need to pay it back.  Businesses were happy - they kept their labour costs under control while at the same time benefiting from hugely increased consumer spending. And the Government was happy, because GDP and tax income were growing due to inflated bank lending and high consumer spending.

The credit bubble burst in 2008 with the near-collapse of two major mortgage lenders (Northern Rock and Bradford & Bingley) and two retail banks (Lloyds TSB and RBS)  together with a raft of other financial institutions throughout the Western world, mainly due to mortgage defaults and rapid house price deflation. Since then, interest rates on unsecured debt, especially credit cards, have soared, and it has become very difficult to obtain mortgages and bank loans. Living costs have risen - notably food, fuel, gas and electricity. Taxes have also risen - VAT, National Insurance, and for higher paid people (who may also have serious debt problems so may effectively be living on very little) lowering of the threshold for higher rate tax and taxation of Child Benefit. So far mortgage rates have not risen, but the other rises are nonetheless making it difficult for many people to maintain their payments. Some benefits are being withdrawn earlier - notably child tax credit - and others are becoming harder to get.  And lenders are now much less patient and accommodating with people in difficulties. Repossession of houses is now occurring not to settle mortgage defaults, but increasingly to settle defaults on unsecured loans. And people who maintain their payments do so at increasing personal cost: many people work harder and harder, and go without more and more, just to ensure they keep up their debt payments. Christians Against Poverty (CAP), who specialise in helping people get out of debt, have stories to tell of people who will go without food rather than fail to make a debt payment.

Well, you might say, people shouldn't have been so stupid as to fall for the illusion of easy money. After all, you don't get something for nothing. But most people I know who have debts they struggle to service have acquired those debts not because they are profligate or spendthrift, but because circumstances made it the best (or even the only) option. They are single parents trying to hold it all together on a low income. They are people who have had periods of illness when their earnings have been very low. They are people doing casual or seasonal work, whose wages vary (but the bills don't). They are people who have lost their jobs and found it hard to get back into work at the same income level they had before. They are self-employed people whose businesses suffered downturns - or whose savings didn't stretch far enough to cover the time needed to build up the business to economic level. They are couples (especially in the South East) who relied on dual income to afford their house but discovered that childcare costs made it uneconomic for one of them to work.  They are people who claimed and were paid child tax credits only to discover they weren't entitled to them and had to pay them back. They are people ripped off by banks mis-selling insurance policies. They are people whose insurance policies wouldn't pay out for household disasters. In short, they are ordinary people who have had problems and solved them in what seemed the easiest and best way at the time. I am one of them.

It seems inevitable to me that a significant proportion of people currently struggling with high levels of debt will end up bankrupt or in IVAs. We are already seeing increases in personal bankruptcies (see statistics in Credit Action's report, op.cit.), particularly among women with children and in depressed areas of the country such as the North East.  Other people with high levels of debt may avoid bankruptcy by selling their homes and using the equity to settle debt. They will end up in the rented housing sector and if they are over 40 will probably never again own their own home. At the other end of the scale it is becoming harder for younger people to buy a house at all because of the difficulty getting a mortgage, the high deposits now required and the fact that many young people who would previously have bought their first home in their mid-20s will not now do so because of the debt they will already be in from their university days. And above all, people will rein in their spending - in fact they are already doing so.  They will go without holidays, new cars, new clothes, improvements to their houses, and concentrate on paying off debt.  Many will stop making provision for their old age in the form of savings and pensions, and use that money to pay down debt instead. After all, what is the point of saving when you owe so much money?

The result of this is that the overall level of debt in the economy will gradually fall.  Debts are written off fully for personal bankrupts, and partially for people in IVAs and others who negotiate settlements with their lenders. Mortgage and unsecured debt settlements will increase as people sell their houses and rent instead. Small businesses will also go bankrupt - many of them due to cash flow difficulties because of the unwillingness of banks to provide working capital at present, and others due to collapse of their market as people stop spending - and any debts they have will also be written off. And people will gradually pay off their debts and will not take on any more.

That sounds positive, doesn't it. But look at the cost. Think of the people who will lose their homes, their possessions, their self-esteem, maybe their jobs (personal bankrupts are barred from some lines of work), maybe their marriages and their friends, maybe even their physical and mental health. Think of the years and years of grinding poverty for many people. And there is an economic cost too. Collapse of consumer demand in an economy is catastrophic for business. All the Government's current economic stimulus measures are aimed only at encouraging business, not at enabling people to spend. If people are not spending, and there is no increase in exports, then businesses will fail whatever stimulus is given.

I have written at length because I really believe no-one is addressing this issue. None of the three main parties have anything to say about the human and economic cost of the high personal debt levels we carry.  All of them are focused so much on controlling Government debt that they don't notice the approaching disaster. Unless they take action on personal debt the UK economy will crash again at some point in the near future, and will not recover for a generation.  This is the appalling legacy from our years of illusory money and delusions of prosperity. Our children, and our grandchildren, will spend their lives paying for our folly.

Friday, 6 May 2011

Demand worries

Commodities market traders behave a bit like sheep - when one runs away, they all do. On Thursday last week, they all fled in droves from commodities. Was this important?

Well, maybe. Initially this looked like an irrational blip - the FT certainly thought so.  The sharpest fall was in silver, largely due to higher cash margin requirements, and it dragged down the rest of the precious metals market. Other commodities fell on short-term panic about possible losses on futures ahead of expected poor world economic growth figures. Now they've got the figures, they aren't panicking any more. The long-term trend is still up. I therefore expect prices in all commodities to rise again shortly. 

Sadly that means this drop will have little or no effect on inflation, and I still think Bernanke will go ahead with QE3. Expect more inflation misery to come.

However, I think this incident is a pointer towards an underlying issue with the way in which the world economy is being managed at the moment. The clear message from this blip for me is that the markets are beginning to worry about falling demand in the world economy.  You don't stimulate demand by fiscal and monetary tightening, as most governments are doing at the moment. It's the wrong medicine.

Monday, 2 May 2011

The worm in the apple: what went wrong in retail banking

In my last post I debunked the myth that the financial crisis was caused by evil investment bankers gambling our precious savings on the international financial casino, and pointed the finger firmly at the massive expansion of high-risk lending by retail banks in the traditional forms of lending - corporate loans, personal loans and in particular mortgages. In this post I shall examine the role of government in encouraging and supporting excessive risk-taking by retail banks, and show that the financial crisis was in fact underpinned - and you could even say, caused - by the implicit support that all governments give to retail banking.

Since my last blogpost the Independent Commission on Banking (ICB)  has produced its draft report. My comments in this blog are inevitably influenced by this report, and at times I shall refer to it directly. But that doesn't mean I agree with it.

I shall start with a discussion of the taxpayers' guarantee for retail depositors.  How many of my readers realise that most retail deposits were actually already guaranteed - not by government - prior to the financial crisis? The Financial Services Compensation Scheme (FSCS) guarantees retail bank deposits up to a practical limit of £31,700.   I should make it clear that the retail deposits protected by this scheme are current accounts and interest-bearing bank (or building society) demand and notice deposit accounts.  ther forms of savings accounts, such as personal pensions, ISAs and high-interest long-term savings linked to life insurance, are also protected by this scheme.  But they are regarded as INVESTMENT accounts and form part of investment banking - and yes, evil investment bankers gamble with that money. That's how they generate the returns.

So when Alistair Darling guaranteed all retail bank deposits to halt the run on Northern Rock, he was committing taxpayers' money to bail out retail deposits in excess of £31,700.  Now why should taxpayers, most of whom are much too poor to have that amount of money sitting around in bank deposit accounts, pay to protect the savings of people who are much better-off than they are?  And pensions and life insurance endowments - the life savings of ordinary people - weren't covered by this guarantee, so remain at risk. Why did he do this? And why did he - and everyone since, including the ICB - regard it as so important that relatively rich retail depositors were protected?

Here's the reason.  Guaranteeing retail deposits has NOTHING to do with preventing people from losing their savings. It is all about keeping banks lending.

Because of the way our financial system works, when banks stop lending it is economically disastrous. Bank lending controls the supply of money in the UK economy. I'm not going to explain here how the fractional reserve banking system works, but in effect all investment in our economy is done by means of bank lending. When banks don't lend, nothing moves - businesses don't grow, people don't spend, government doesn't invest.  Although banks can invent the money they lend, they do have to have some money in reserve to settle that lending. Some of that cash is provided by retail deposits.  But they can also borrow cash cheaply to settle loan drawdowns, either from other banks (notably investment banks) or from the central bank.  So why do they need deposits?  The answer is, they don't - but people think they do.

Banking textbooks insist that bank lending is made up of fractions of deposits they receive from retail savers.  The "money multiplier" is routinely taught as the mechanism by which banks are able to lend.  It is therefore widely believed that banks can only lend if people and businesses provide money in the form of deposits.  The more money retail depositors put into banks, the more money banks can lend out.  The more money banks lend out, the more the economy grows, and the more revenue government receives in taxes and can spend on things like the welfare state.

We (people, businesses, government) want banks to lend. Because of it we can afford things we couldn't otherwise have. That has been the model for a long time and I haven't seen as yet any serious plans to change it. In fact in the last twenty years banks, encouraged by financial deregulation and free market economics, massively expanded their lending, and we (people, business, government) lapped it up and begged for more.  The result was a credit bubble, which in turn fuelled a housing price bubble, which when it collapsed brought down the financial system.  Many people who bought into the credit bubble are now saddled with heaps of debt they struggle to repay.  Many people who bought into the housing price bubble lost their homes.  Many, many people have seriously lost confidence in the whole banking system. Bankers are currently the most hated people on the planet.

If retail depositors lose confidence in the banks and stuff their money under the mattress instead, the money multiplier tells us that banks' ability to lend is seriously reduced.  This isn't true, because banks will simply borrow the money for loan settlement from somewhere else. But people - even those who should know better - believe that lending will collapse if retail deposits disappear. Therefore government will provide unlimited support to retail depositors to ensure a continuing supply of money to support lending. Hence the almost hysterical insistance by almost everybody that it is ESSENTIAL to guarantee retail deposits.  Indeed it is, if you believe the money multiplier.  Lose your retail deposits and you lose your financial system.

This need is so acute that quite silly measures may be taken to protect retail deposits. Full separation of investment and retail banking not only doesn't protect against future failures, it significantly reduces returns to both retail depositors and, even more, to pension and endowment holders.  But if retail depositors believe that their money is put at risk by evil investment bankers gambling with their money, they will cry out for full separation - and government will give in to them even though it doesn't solve anything. In proposing ring-fencing of retail banking the ICB has attempted to calm depositors' fears enough to avoid full separation - but it admits that this might not work and the government might still have to agree to full separation.

It's all about confidence, in the end.  In fact the whole thing really is a confidence trick. Blame investment banking for a crisis actually caused by stupidly risky retail lending, because if you undermine confidence in retail banks people might move to credit unions and small building societies instead (which don't generate money for the economy). Tell retail depositors you are concerned that they should not lose their savings, when what you are actually doing is ensuring a supply of cash reserves to the banks so that they can lend even more.  And above all, pretend that the financial system works the way it does because there is no other way of organising it, and that bank lending is a good thing, really.  Well, ok, bank lending to people that can't afford it maybe isn't such a good thing. But bank lending to businesses is good, isn't it? That's what we are hearing at the moment. "Get the banks lending to businesses! Get the economy moving!" And what happens when banks lend silly amounts of money to businesses that turn out to be insolvent? Yes, you guessed - the taxpayer coughs up again. Serious losses in corporate and commercial lending were contributory factors in the failure of both RBS and HBOS.

The worm in the apple is the retail depositors' guarantee. Unlimited taxpayer support of what is a fairly large proportion of retail bank cash reserves means that banks can continue to take stupid risks in retail lending in the certain knowledge that they will be bailed out every time.  Yes, under the ICB proposals investment banks would not be bailed out once retail banking is ring-fenced.  But retail banks still will be supported end-to-end by an unlimited taxpayers' guarantee.  Roll on the next financial crisis and bank bailout. Wonder who we'll blame next time? I guarantee it won't be retail banking.

It doesn't have to be like this. We really don't have to be so dependent on bank lending. Let's find a better way of organising our financial system. Break the link between bank lending and economic growth. Get rid of taxpayers' guarantees for well-off people.  Force banks to manage their risks properly.  And above all, recognise that prosperity founded on credit is an illusion which can't be sustained. Real growth comes from real money, generated by real people buying and selling real goods and services.