Tuesday, 14 October 2008


For over ten years now the Western world has pushed its so called economic growth by consumption, but without the resource to pay for that consumption. Private individuals spent, and government spent. The Private Finance Initiative was an example of private firms providing the government with public buildings and services for a later rental: an example of get now pay later.

At the same time the Far East and Middle East have built up savings surpluses, which should have been generated in the Western economies. Had this been the case, growth would have been much lower, but would have been sustainable.

In this time, the West has developed ways of handling debt that hid the fact that it was debt, so that the lending of the credit was sustained by a system that rewarded transactions rather than surpluses.

The root of the problem is the bizarre mental turnaround of immediate sense in banking that makes white look black. It is that what looks like an asset is a liability and what looks like a liability is an asset. It only needs to be a few steps removed, and the trading is in assets that seem to be assets.

When someone saves money in a bank, the bank gets the money, but it is a liability. So something physical and present is like a loss. When a bank lends money, it loses money and yet is an asset. So something that is lost becomes as if present - an asset.

Now, of course, the application and interview with the bank person is all important. There should be an assessment of risk. The money given away is an asset because it has to come back, and it will come back after many payments for having it. The amount of payment made back should reflect the risk, and the sending money out may even be refused in the first place. However, when transactions get rewarded rather than surpluses, then the tendency is to lend to anyone. Furthermore, assets get bundled with others and become something to sell.

Then it gets complicated because the risk of the bundled asset can be insured against to reduce the risk. Payments are made to reduce the risk, and they go to a derivative. Should the asset fail, there is like an insurance payout from the derivative. However, the derivative is itself a probability of failure, and so can be bought and sold by anyone, and not just the buyer of an asset. So risk reducing derivatives become like assets in their own right. Well, it's like money sloshing around looking for a win on derivatives. It is about a money supply far too high, and not being backed by production: a consumption economy is a charade.

This depends on a lack of regulation and cheap money, but the result is a vast amount of lending to anyone and a demand on housing (and on goods and services) that would otherwise not be made. Thus house prices rise: incidentally those productive low cost countries take the demand for consumer goods, and this build up surpluses based on Western debt.

Housing and land are limited, and the point about housing is the wealth effect. As too many people borrow what they cannot afford, house prices rise, there is plenty of DIY and doing up properties, and this is interpreted as wealth. But it isn't: it is displaced credit finding a place to go, rather like fat in people who eat too much. Then you get the bizarre situation of schemes to help people get on the property ladder (eg part buy, part rent) that only pushes house prices up higher.

As the credit vanishes house prices crash, and debts vanish. The credit crunch is that banks fear assets are not assets, so lending to get assets stops. Those cash deposits called liabilities are suddenly important to a bank, though of course a run on the bank finishes it off. It has no cash in hand, and assets that fail - though banks have failed because too many assets have failed.
One plan of government rescue in the US was to buy up bad assets, and thus banks could resume lending to get assets. But they lacked confidence in the assets they might get. Gordon Brown's plan has been to inject capital, but what about this?

It should mean interbank lending rates coming down, and lending to people they might not now. The central banks reduced their rates, again an anti-credit shrinkage measure. But does not all these interventions mean a continuation of credit as in the recent past? The government intervention backs this activity up. Meanwhile liquidity has been raised via shares and the government buying so many: that the government risk now will be repaid in years to come by selling the shares again at vastly increased prices. Will the government then be tempted to spend the windfall, when it should get rid of debt?

My thought is this. Whilst the liquidity injection means firms can borrow to invest and wages will get paid, and a bank can get money lend so to generate mortgages, etc., nevertheless the credit reducing effect of shutting some firms in the real economy means that lending has to reduce. Banking failures can follow downturns in the rest of the economy.

Banking failure was like a gun to the government's head, because this would have caused the rest of the economy to malfunction, but the glued up banks may well stay a little sticky - and perhaps they should.

The government would do well to assist productive activity and also it must increase housing supply. Never again should there be a wealth effect in property. Savings have to be encouraged. So far there is a rescue plan, but in the longer term these measures are more of the same, and it is what we do not need. Banks that once used to refuse to lend often did so because the loans were too risky; the client simply had not demonstrated a future ability to pay. The collateral can be returned, but it too has a value, and values going down mean the loan given can't be returned (of course).

These assets are in the future, as income generators, and need to be more reliable. This means fewer, and so does a recession.

Interesting, all this, how the financial crisis indicates the need for a Covenant of trust and expectation, along with sheer contracts. The regulatory framework is like this too: that it backs up what is also needed and that is trust.

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