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Well, the economy is back in the news again. Most obviously the headlines this week that the UK economy has slipped back into recession. Chancellor George Osborne has put on his serious face and shaken his head meaningfully and talked about global problems bringing the otherwise vibrant and lively British economy down. In the meantime Shadow Chancellor Ed Balls has adopted his more-in-sorrow –than-anger tone and toured the media offices to explain how if George had just done like he suggested everything would be fixed by now and we’d be bustling along like nobody’s business.
There’s been a certain amount of lively debate between supporters of the main parties about which one is right but that debate has as far as I can see missed the most important single point: they’re both lying.
I give them both credit for being intelligent fellows who’ve got a good idea of what is actually going on. Ed Balls is a pathetically delusional figure so hung up on his own correctness that he’s incapable of acknowledging any flaws in his own thinking or any personal responsibility he might hold for the economy being in the hole it is in, but I don’t consider him thick. In the same light Osborne isn’t dumb, but he can’t tell the truth about the economy because if he did then the ratings agencies would have stop pretending they think we’re a good credit risk and giving us a AAA thumbs up. When anti-Osborne people say that what he should be doing is creating a ‘plan for growth’, they’re either making political hay from a safe distance (in which case they’re playing games with the hopes and live of millions, and I despise them), or they haven’t the faintest of just what things are actually like, in which case they should just keep their traps shut because anyone talking about a ‘plan for growth’ fails to acknowledge the simple fact that right now there’s no such thing.
It’s been observed that in 2009-10 Alistair Darling as Chancellor delivered four consecutive quarters of economic growth, and the figures would seem to support this. Anti-Osborne voices use this to demonstrate just how superior Labour’s economic management was, but clearly they’ve never heard the market term ‘relief rally’. The truth of that growth is simple: if you let me print two hundred billion quid like Darling did, I can give you all the illusion of growth you like until the artificial liquidity that pumps into the economy is spent. Then you’re either back where you started with the option of either printing more money (and who likes having savings anyway?), or tackling the underlying problems. Like blowing more air into a balloon with a hole in it, you can keep it inflated but it doesn’t fix the hole. At best all you’ve done is bought a little time, and what is desperately needed at the moment is time.
The growth figures are so artificial as to be meaningless. They’re seized upon by economic and political commentators and activists to support their personal ideologies and advance their position in debate, but the reality is that it is very unlikely that the UK economy has come out of recession at all since 2007.
In the meantime, the Eurozone has announced that they will be abandoning austerity and ‘going for growth’. This is rather like a morbidly obese coronary patient saying they’re abandoning the starvation diet and going for donuts. When what is needed is an entire change of lifestyle, what’s being tried is wild swings between what got them into this mess in the first place and desperate expenditure reductions. When Mario Draghi pops up on the day Spanish unemployment went over 25% to explain how the problems with the Euro are fixed and then the very next day the President of the European Parliament says that the breakup of the EU is a very real possibility what you’ve got to take away from that is that the cracks are really starting to show.
It’s instructive to understand how we got where we are now. In the dying days of his pathetic, failed leadership, Gordon Brown used to bleat that the crisis ‘started in America’. Like Dr Manhattan says at the end of Watchmen ‘In the end? Nothing ever truly ends’, it’s nigh impossible to put your finger on where the crisis actually started. You can point to the collapse of the London gold pool in the 1960s and Nixon taking the dollar off the gold standard and the subsequent exponential growth of credit if you like, but there are several major moments in the last decade and a half which were critical. The removal of London bank capital restrictions in 1997 was pivotal. Before this Retail banking (your money) and Investment banking (the bank’s money) were held legally separate. Afterwards, the banks were allowed to start investing – or gambling, call it what you will – with your money in London. This caused the global banking industry to shift to the city wholesale and in turn led to Clinton repealing the Glass-Steagall act (you may have heard of it) to prevent the entire US financial industry heading over the Atlantic pronto. In the wake of the dotcom bust and 9/11 interest rates were dropped worldwide in an attempt to forestall a recession and encourage a return to growth. This worked, but created a credit and property price boom. As cheap money expanded – over the next half decade UK personal debt increased by over £1trn – two things happened. First, a this personal debt fed back into the economy resulting in growth, as had been intended, and a great increase of state taxation revenues which allowed a spending spree of unprecedented proportions. Secondly it created an asset price bubble. As the state was taxing savings, and interest rates reduced any remaining saving values people (I may have said this was going to happen back in 2005, but I never go on about it) piled into property as a ‘safe haven’ for their money and drove up the prices into a bubble worldwide. ‘Sub-Prime’ (i.e people with no jobs, income or collateral for loans) lending against mortgages grew hugely. These loans would be bundled and sold on the derivatives market; oodles of cash was made in commissions and also tax revenues. It was in nobody’s interest for it to stop.
Well, when I say ‘nobody’s’ what I mean is ‘nobody in either government or the financial services industry’. It was totally in yours and my interest for it to stop, but nobody wanted to hear it for as long as they could believe that Brown had ended boom and bust. To put this into perspective, when you look at the GDP growth figures and compare them with the actual productivity growth figures for the last decade, it appears to there was no real growth in the UK economy whatsoever from 2002 onwards. All the appearance of growth thereafter was based on the expansion of cheap credit. The thing about cheap credit is that it leads to what’s called ‘malinvestment’; instead of borrowing money to invest in things that grow and produce a return in future, people borrow money to pay for holidays and the like. Leisure activity, which creates no growth or return. As a result, there has been no real productivity growth in the UK for a decade at least, and all it took was for a generation to be indebted. Estimates are that once this has all been unwound, the average standard of living in the UK will return to what it was in 2005. It will be hell. People might have to do without Ipads.
The economy is chaotic; a Massively complex system with containing millions of discrete, independent agents from which patterns emerge. Chaos theory predicts that as patterns begin to fail you will first see ‘judders’ within the system which presage that collapse. The failure of Northern Rock in 2007 was such a leading event which was mathematically telling. The government rescue of the Rock was an attempt to shore up the system as it began to fail – an act which only made things worse (You know, I could have sworn I said that at the time). The true failure came a year later. Most believe call this the ‘Lehman event’ – the failure of Lehman brothers, but that wasn’t the actual point of failure. The point of failure was the London office of insurers AIG where a fellow by the name of Joseph Cassano and his team were selling Credit Default Swaps (CDSs), a form of insurance on credit. The idea is that if you lend someone money you take out a CDS contract to indemnify you against the possibility of them defaulting. Cassano and his team had sold US$2.7 trillion in CDS insurance against the mortgage market and – this is the important bit – didn’t have a bean in back it up with. So long as the housing market kept going up and defaults were offset by new people entering into the market, the team could pay up. The instant the housing market slowed and more people exited than entered, the jig was up. The mortgage derivative market seized as the security – the mortgagee – defaulted and the insurance didn’t cover the loss. The entire system cascade failed as suddenly nobody knew which derivatives had value and which didn’t. Banks would not lend to each other as they couldn’t be sure if they’d get their money back (as the assets banks were claiming were largely derivative backed, and suddenly their value had collapsed) and they couldn’t even be sure their own assets had any value. This is where the phrase ‘credit crunch’ came from.
So governments stepped in and guaranteed the assets, allowing banks to start lending to each other – and, more importantly, you. As your money was allowed to be used as investment capital and collateral (thanks to the 1997 ruling) it wasn’t just the bank money which had gone, it was yours as well. For a moment, the entire system teetered.
The thing is, when governments guaranteed those dodgy assets there’s no way of knowing how much they actually were. The way derivatives were sold meant it was very hard indeed to tell what was good and what wasn’t (deliberate? Maybe…) and so a lot of what was called ‘contingent liability’ was adopted by the taxpayer. The derivative assets being held by banks are being shown on their books at face value, and their balance sheets of profit and loss reflect that. The thing is, nobody has the first clue what these derivatives are actually worth until they go wrong – or don’t – but this isn’t reported. When people say that the bank baiulouts will show a profit, they can’t know that. The contingent liabilities – the assets which nobody has the first clue about – could well be worthless, and this risk isn’t shown anywhere in the financial reporting. All that is shown are those debt and derivatives which have already gone bad. Do any of you believe that it’s all out in the open and all the bad debt is now dealt with? Anyone? No?
Some people say that the state bailouts saved the system. That your money is safe. This ain’t necessarily so. You see, your assets, your money, can still be used as collateral for loans and deals, and are being. And there isn’t enough money anywhere to save the system twice. When MFGlobal, a major clearing house, collapsed last year, they held hundreds of billions of client assets – money and goods belonging to savers and investors like you which legally did not belong to the bank. They even held physical assets like gold for clients. In the aftermath of the collapse, these assets – which, remember, neither the bank nor their creditors had any legal right to – had gone. The term used was ‘evaporated’. It’s likely that none of those investors will ever see their money or assets again. To date, nobody has gone to prison, or even been charged.
So why is London the epicenter of all of this?
Well, you see; when your bank lends you money, it creates what your bank calls an asset. That asset is your debt, and it has value. If you take out a mortgage for, say, £100k the banks holds an asset which is your debt secured against your house. It can then use this asset as security to borrow money itself, which it then lends on again and so forth. This process is called ‘hypothecation’ (the bank hypothetically has your house) and ‘rehypothecation’ (the bank uses your house as security on other debt secured against your ongoing ability to pay) So long as you keep paying your mortgage all is well.
Now in most places in the world, there are limits to rehypothecation. The most you can rehypothecate is 140% of the value of the asset (so if you have a 100k mortgage, the bank can use that as security against 140k of additional debt). However, in London there are no limits on rehypothecation whatsoever. So long as you hold an asset, you can borrow as much as you damn well please against it subject to how much risk you’re prepared to take. Rehypothecation of up to 400% is not unusual (So if you have a 100k mortgage the bank has borrowed 400k against your ability to pay, and what happens if you can’t pay? Oh, yeah, that.), and what’s more, rehypothecated assets do not have to appear on bank balance sheets. Like Gordon Brown keeping PFI 'off balance sheet' to help his pretence that he was competant and hide the true state of the national finances, so rehypothecated assets and their liabilities are off balance sheet too. When a bank says it has liabilities of so many billions, they’re missing all this stuff off. Welcome to the shadow banking system.
What’s more, the thing you really have to remember is that it wasn’t just the hundreds of billions in dodgy sub-prime mortgages which were rehypothecated. The same has also happened to trillions of Eurozone debt; and that’s where it’s instructive to take a quick look at the EU.
The inherent problems of the Eurozone have been covered in so much depth recently that it’s probably not worthwhile to go over them here, but the short version is; different economies in Europe are differently efficient, but they’re all using the same currency. However, they’re all allowed to set their own tax rates, print their own cash, borrow on their own account etc without any central coordination. Without full currency union, the weaker members can leverage themselves against the productivity of the stronger in order to support their own economies and hide their own failings, and there’s nothing to stop them. This is precisely what happened. This works just fine until credit dries up and interest rates rise, at which point the interest on money raised by the economically weaker nations becomes unaffordable. This was another of those things that ‘nobody saw coming’ and that’d be believable if I hadn’t been saying this was going to happen in 2009. There’s a great arcticle about how Greece went wrong here if you care to glance over it.
Now, the European Parliament has been saying – for most of the last year – that the problems with the Euro have been solved. They haven’t been telling the truth up until now, and they’re haven’t suddenly started. Greece is the poster boy for the ills of the Eurozone, and it’s well known that they agreed a 75% writedown on their debt a few months ago. Thus, we are told, the problems with Greece were solved.
Bullshit.
I don’t swear much on there, but sometimes you just have to. To understand why this this is rubbish, you have to understand the bond markets; the way government bonds work is that they issue a bond for, say, E100,000 over ten years. This bond will pay you 1.5% of the face value (E1,500) every year until the ten years are up and then you get the 100K you paid for originally. Under normal circumstances a Triple A rated nation will sell bonds at about 2-3% interest – so that’s a discount to the 100k the bond is worth as the E1,500 a year is 2% of what you paid for it. That’s why when the news says that bond interest rates have gone up it’s a bad thing. Even after the 75% writedown, Greek bonds are trading at 13.75%, meaning that you can buy 100k of Greek debt for about E10,000. As a general rule, anything of 6% is bad news. Nobody, even now, thinks Greece can pay its debts. And they can’t.
You see, the problems is that most bonds are issued under the laws of the issuing country – it’s how they can force a writedown if they need to. You, as the bondholder, can agree to take the loss, or the country can re-write its laws to make the bonds you hold worthless. The problem Greece has is that about 20% of state debt was sold on bonds issued under English law, and that’s not getting changed to get them off the hook – so that’s about E28bn they have to find regardless. What’s more, what hasn’t been mentioned is the Greek state companies – like the Greek railways – which also issued their bonds under English law. There’s another E100bn in debt sitting there which the Greek government is also on the hook for and everyone is staying very…quiet…about and hoping it will go away.
If it were just Greece, this wouldn’t be so bad, but it isn’t. Spain, Portugal and Italy are in the same boat – they can’t pay their debts. It’s looking like Ireland may need another bailout despite introducing the stringent austerity measures demanded of them. And the stronger Eurozone nations? Well, lets look at some numbers, shall we?
• Take Belgium; With a GDP of E467bn, they have public sector debt of E466bn, and when the bank Dexia went under last year the government bailed it out by underwriting another E116bn of bad debt not counting contigent liabilities.
• When Greece was bailed out, we were told that Greek debt would peak at 120% of GDP in five years and then start to fall. It's already there.
• Portuguese public sector debt is 140% of GDP and rising.
• In order to offset outstanding liabilities falling due within the next few years the ECB will need to print at least an additional 2 trillion Euros.
• French and German banks are estimated to have over E200bn in unfunded liabilities and, unlike the British, the French and Germans haven’t even started recapitalising their banks yet.
• According to the European central bank, Eurozone banks are E2.78trn short of the capital required to make them safe in the event of future financial shocks.
• One third of Eurozone banks cannot meet even 'tier 3' funding requirements of 3% of liability.
• The ECB is accepting from Eurozone banks as collateral for loans those self-same dodgy derivatives and Eurozone debts which are unpayable, and it is accepting them at face value thereby saddling the EU taxpayers with the liabilities.
Across the Eurozone, total net debt liabilities are estimated to be well in excess of ten trillion Euros. And that brings us back to London, because thanks to unlimted rehypothecation of assets – i.e. the debts held by London institutions - in the shadow banking system is it estimated that anything up to another eight trillion Euros in liabilities is sitting there off balance sheet and unreported.
If you stop and think about it, suddenly everything George Osborne is doing makes sense. He has to buy time for the London financial services industry to unwind its Eurozone position, as if the Euro splits then it will take London with it and for as long as the government of the UK is reliant on the financial services industry for 40% of tax revenues that’s just not going to be something to take risks over. Similarly if London goes under it’ll take the Eurozone with it, so he can’t push for the stupidity taxation on the city. Like King Lear and his fool clinging to each other for fear of the tempest which rages about them, London and the Eurozone are inextricably linked until the entire sorry situation can be unwound. The colossal, unfunded liabilities of the Eurozone and the financial services industry. So Osborne drips liquidity into the system; a bit of tax here, a bit of QE there, a donation to the IMF to prop the Euro up for another day, buying time for the city to get out of the hole it dug for itself.
There aren’t many ways out of this. A decade of slow – if any – growth, cuts and austerity may be the best solution. Monetising debt, by which I mean printing money and buying the debts and then just forgetting about them, is another route being pursued. This has the side-effect of inflation which might reduce the value of your savings but at least it means they won’t evaporate when your bank goes under and it’s found all your money not only now belongs to someone else, but in same cases never even existed.
Globally, things look the same. The distant flushing noise you hear from the East is Chinas’ growth estimates vanishing down the lavatory as their construction sector grinds to a halt; 30-40%% of Chinese government tax revenues are generated by the construction sector. India is relying on the monsoon this year being a particularly good one to restore their economy to growth. The US is US$16trn in debt and that figure has risen 16% in the last 24 months. If you want a prediction, it’s that the US will announce a further QE programme of between 5-700bn at some point between July and September this year. Global GDP is estimated at US$59trn. Global debt liabilities are estimated at US$220trn.
As some southern European countries attempt to ban large transactions taking place in cash to clamp down on tax avoidance (the Spanish are talking about introducing a law that any cash transaction of over E1,000 must be carried out in the presence of a tax inspector), people are shifting from money to barter as globally the financial system strains. From this town in Greece where people have given up on money and gone back to barter, to China buying US21bn in oil from Iran with a combination of goods, services and gold rather than actual money.
Economists – especially ones who aren’t going to lose their jobs if they turn out to be wrong - have said that the way out of the credit crisis is, ultimately, to increase the money supply. Or maybe we can ‘abandon austerity and go for growth’. You know, the next time someone says that, point out that the UK has taken on liabilities of almost two trillion quid in the last decade or so and printed two hundred and seventy five billion more. You might ask them, given that this printing and borrowing doesn't seem to have resulted in all that much growth, just how much more we need to borrow before it starts working. Alternatively, just punch them in the face. It’ll be quicker.
In the light off all that increase in debt and printing, the best performing asset class since the start of 2012 has been bullion.
Hang on, wasn’t I saying that would happen last August? Why, yes. Yes I was. I do hope you were listening.
Some people have said that the way for the UK to cut the deficit and still avoid state spending cuts is for the rich to pay their 'fair share'. To put that into perspective, if Britain's two richest men (Lakshmi Mittal and Alisher Usmanov) were to write cheques to the treasury for their entire net worth tomorrow, that'd just about cover the deficit and cuts until the middle of June. If everyone in the top 1,000 richest people in the UK were taxed every single penny they own, it'd get us until about this time next year. Who, precisely, are we supposed to tax 'fairly' after that? It's no more a long-term solution than printing money is.
Economically, the current level of state debt, liabilities and spending are not sustainable - and the one thing you can say with absolute certainty about things which are not sustainable is that they will not be sustained.
Just sayin'.
There’s been a certain amount of lively debate between supporters of the main parties about which one is right but that debate has as far as I can see missed the most important single point: they’re both lying.
I give them both credit for being intelligent fellows who’ve got a good idea of what is actually going on. Ed Balls is a pathetically delusional figure so hung up on his own correctness that he’s incapable of acknowledging any flaws in his own thinking or any personal responsibility he might hold for the economy being in the hole it is in, but I don’t consider him thick. In the same light Osborne isn’t dumb, but he can’t tell the truth about the economy because if he did then the ratings agencies would have stop pretending they think we’re a good credit risk and giving us a AAA thumbs up. When anti-Osborne people say that what he should be doing is creating a ‘plan for growth’, they’re either making political hay from a safe distance (in which case they’re playing games with the hopes and live of millions, and I despise them), or they haven’t the faintest of just what things are actually like, in which case they should just keep their traps shut because anyone talking about a ‘plan for growth’ fails to acknowledge the simple fact that right now there’s no such thing.
It’s been observed that in 2009-10 Alistair Darling as Chancellor delivered four consecutive quarters of economic growth, and the figures would seem to support this. Anti-Osborne voices use this to demonstrate just how superior Labour’s economic management was, but clearly they’ve never heard the market term ‘relief rally’. The truth of that growth is simple: if you let me print two hundred billion quid like Darling did, I can give you all the illusion of growth you like until the artificial liquidity that pumps into the economy is spent. Then you’re either back where you started with the option of either printing more money (and who likes having savings anyway?), or tackling the underlying problems. Like blowing more air into a balloon with a hole in it, you can keep it inflated but it doesn’t fix the hole. At best all you’ve done is bought a little time, and what is desperately needed at the moment is time.
The growth figures are so artificial as to be meaningless. They’re seized upon by economic and political commentators and activists to support their personal ideologies and advance their position in debate, but the reality is that it is very unlikely that the UK economy has come out of recession at all since 2007.
In the meantime, the Eurozone has announced that they will be abandoning austerity and ‘going for growth’. This is rather like a morbidly obese coronary patient saying they’re abandoning the starvation diet and going for donuts. When what is needed is an entire change of lifestyle, what’s being tried is wild swings between what got them into this mess in the first place and desperate expenditure reductions. When Mario Draghi pops up on the day Spanish unemployment went over 25% to explain how the problems with the Euro are fixed and then the very next day the President of the European Parliament says that the breakup of the EU is a very real possibility what you’ve got to take away from that is that the cracks are really starting to show.
It’s instructive to understand how we got where we are now. In the dying days of his pathetic, failed leadership, Gordon Brown used to bleat that the crisis ‘started in America’. Like Dr Manhattan says at the end of Watchmen ‘In the end? Nothing ever truly ends’, it’s nigh impossible to put your finger on where the crisis actually started. You can point to the collapse of the London gold pool in the 1960s and Nixon taking the dollar off the gold standard and the subsequent exponential growth of credit if you like, but there are several major moments in the last decade and a half which were critical. The removal of London bank capital restrictions in 1997 was pivotal. Before this Retail banking (your money) and Investment banking (the bank’s money) were held legally separate. Afterwards, the banks were allowed to start investing – or gambling, call it what you will – with your money in London. This caused the global banking industry to shift to the city wholesale and in turn led to Clinton repealing the Glass-Steagall act (you may have heard of it) to prevent the entire US financial industry heading over the Atlantic pronto. In the wake of the dotcom bust and 9/11 interest rates were dropped worldwide in an attempt to forestall a recession and encourage a return to growth. This worked, but created a credit and property price boom. As cheap money expanded – over the next half decade UK personal debt increased by over £1trn – two things happened. First, a this personal debt fed back into the economy resulting in growth, as had been intended, and a great increase of state taxation revenues which allowed a spending spree of unprecedented proportions. Secondly it created an asset price bubble. As the state was taxing savings, and interest rates reduced any remaining saving values people (I may have said this was going to happen back in 2005, but I never go on about it) piled into property as a ‘safe haven’ for their money and drove up the prices into a bubble worldwide. ‘Sub-Prime’ (i.e people with no jobs, income or collateral for loans) lending against mortgages grew hugely. These loans would be bundled and sold on the derivatives market; oodles of cash was made in commissions and also tax revenues. It was in nobody’s interest for it to stop.
Well, when I say ‘nobody’s’ what I mean is ‘nobody in either government or the financial services industry’. It was totally in yours and my interest for it to stop, but nobody wanted to hear it for as long as they could believe that Brown had ended boom and bust. To put this into perspective, when you look at the GDP growth figures and compare them with the actual productivity growth figures for the last decade, it appears to there was no real growth in the UK economy whatsoever from 2002 onwards. All the appearance of growth thereafter was based on the expansion of cheap credit. The thing about cheap credit is that it leads to what’s called ‘malinvestment’; instead of borrowing money to invest in things that grow and produce a return in future, people borrow money to pay for holidays and the like. Leisure activity, which creates no growth or return. As a result, there has been no real productivity growth in the UK for a decade at least, and all it took was for a generation to be indebted. Estimates are that once this has all been unwound, the average standard of living in the UK will return to what it was in 2005. It will be hell. People might have to do without Ipads.
The economy is chaotic; a Massively complex system with containing millions of discrete, independent agents from which patterns emerge. Chaos theory predicts that as patterns begin to fail you will first see ‘judders’ within the system which presage that collapse. The failure of Northern Rock in 2007 was such a leading event which was mathematically telling. The government rescue of the Rock was an attempt to shore up the system as it began to fail – an act which only made things worse (You know, I could have sworn I said that at the time). The true failure came a year later. Most believe call this the ‘Lehman event’ – the failure of Lehman brothers, but that wasn’t the actual point of failure. The point of failure was the London office of insurers AIG where a fellow by the name of Joseph Cassano and his team were selling Credit Default Swaps (CDSs), a form of insurance on credit. The idea is that if you lend someone money you take out a CDS contract to indemnify you against the possibility of them defaulting. Cassano and his team had sold US$2.7 trillion in CDS insurance against the mortgage market and – this is the important bit – didn’t have a bean in back it up with. So long as the housing market kept going up and defaults were offset by new people entering into the market, the team could pay up. The instant the housing market slowed and more people exited than entered, the jig was up. The mortgage derivative market seized as the security – the mortgagee – defaulted and the insurance didn’t cover the loss. The entire system cascade failed as suddenly nobody knew which derivatives had value and which didn’t. Banks would not lend to each other as they couldn’t be sure if they’d get their money back (as the assets banks were claiming were largely derivative backed, and suddenly their value had collapsed) and they couldn’t even be sure their own assets had any value. This is where the phrase ‘credit crunch’ came from.
So governments stepped in and guaranteed the assets, allowing banks to start lending to each other – and, more importantly, you. As your money was allowed to be used as investment capital and collateral (thanks to the 1997 ruling) it wasn’t just the bank money which had gone, it was yours as well. For a moment, the entire system teetered.
The thing is, when governments guaranteed those dodgy assets there’s no way of knowing how much they actually were. The way derivatives were sold meant it was very hard indeed to tell what was good and what wasn’t (deliberate? Maybe…) and so a lot of what was called ‘contingent liability’ was adopted by the taxpayer. The derivative assets being held by banks are being shown on their books at face value, and their balance sheets of profit and loss reflect that. The thing is, nobody has the first clue what these derivatives are actually worth until they go wrong – or don’t – but this isn’t reported. When people say that the bank baiulouts will show a profit, they can’t know that. The contingent liabilities – the assets which nobody has the first clue about – could well be worthless, and this risk isn’t shown anywhere in the financial reporting. All that is shown are those debt and derivatives which have already gone bad. Do any of you believe that it’s all out in the open and all the bad debt is now dealt with? Anyone? No?
Some people say that the state bailouts saved the system. That your money is safe. This ain’t necessarily so. You see, your assets, your money, can still be used as collateral for loans and deals, and are being. And there isn’t enough money anywhere to save the system twice. When MFGlobal, a major clearing house, collapsed last year, they held hundreds of billions of client assets – money and goods belonging to savers and investors like you which legally did not belong to the bank. They even held physical assets like gold for clients. In the aftermath of the collapse, these assets – which, remember, neither the bank nor their creditors had any legal right to – had gone. The term used was ‘evaporated’. It’s likely that none of those investors will ever see their money or assets again. To date, nobody has gone to prison, or even been charged.
So why is London the epicenter of all of this?
Well, you see; when your bank lends you money, it creates what your bank calls an asset. That asset is your debt, and it has value. If you take out a mortgage for, say, £100k the banks holds an asset which is your debt secured against your house. It can then use this asset as security to borrow money itself, which it then lends on again and so forth. This process is called ‘hypothecation’ (the bank hypothetically has your house) and ‘rehypothecation’ (the bank uses your house as security on other debt secured against your ongoing ability to pay) So long as you keep paying your mortgage all is well.
Now in most places in the world, there are limits to rehypothecation. The most you can rehypothecate is 140% of the value of the asset (so if you have a 100k mortgage, the bank can use that as security against 140k of additional debt). However, in London there are no limits on rehypothecation whatsoever. So long as you hold an asset, you can borrow as much as you damn well please against it subject to how much risk you’re prepared to take. Rehypothecation of up to 400% is not unusual (So if you have a 100k mortgage the bank has borrowed 400k against your ability to pay, and what happens if you can’t pay? Oh, yeah, that.), and what’s more, rehypothecated assets do not have to appear on bank balance sheets. Like Gordon Brown keeping PFI 'off balance sheet' to help his pretence that he was competant and hide the true state of the national finances, so rehypothecated assets and their liabilities are off balance sheet too. When a bank says it has liabilities of so many billions, they’re missing all this stuff off. Welcome to the shadow banking system.
What’s more, the thing you really have to remember is that it wasn’t just the hundreds of billions in dodgy sub-prime mortgages which were rehypothecated. The same has also happened to trillions of Eurozone debt; and that’s where it’s instructive to take a quick look at the EU.
The inherent problems of the Eurozone have been covered in so much depth recently that it’s probably not worthwhile to go over them here, but the short version is; different economies in Europe are differently efficient, but they’re all using the same currency. However, they’re all allowed to set their own tax rates, print their own cash, borrow on their own account etc without any central coordination. Without full currency union, the weaker members can leverage themselves against the productivity of the stronger in order to support their own economies and hide their own failings, and there’s nothing to stop them. This is precisely what happened. This works just fine until credit dries up and interest rates rise, at which point the interest on money raised by the economically weaker nations becomes unaffordable. This was another of those things that ‘nobody saw coming’ and that’d be believable if I hadn’t been saying this was going to happen in 2009. There’s a great arcticle about how Greece went wrong here if you care to glance over it.
Now, the European Parliament has been saying – for most of the last year – that the problems with the Euro have been solved. They haven’t been telling the truth up until now, and they’re haven’t suddenly started. Greece is the poster boy for the ills of the Eurozone, and it’s well known that they agreed a 75% writedown on their debt a few months ago. Thus, we are told, the problems with Greece were solved.
Bullshit.
I don’t swear much on there, but sometimes you just have to. To understand why this this is rubbish, you have to understand the bond markets; the way government bonds work is that they issue a bond for, say, E100,000 over ten years. This bond will pay you 1.5% of the face value (E1,500) every year until the ten years are up and then you get the 100K you paid for originally. Under normal circumstances a Triple A rated nation will sell bonds at about 2-3% interest – so that’s a discount to the 100k the bond is worth as the E1,500 a year is 2% of what you paid for it. That’s why when the news says that bond interest rates have gone up it’s a bad thing. Even after the 75% writedown, Greek bonds are trading at 13.75%, meaning that you can buy 100k of Greek debt for about E10,000. As a general rule, anything of 6% is bad news. Nobody, even now, thinks Greece can pay its debts. And they can’t.
You see, the problems is that most bonds are issued under the laws of the issuing country – it’s how they can force a writedown if they need to. You, as the bondholder, can agree to take the loss, or the country can re-write its laws to make the bonds you hold worthless. The problem Greece has is that about 20% of state debt was sold on bonds issued under English law, and that’s not getting changed to get them off the hook – so that’s about E28bn they have to find regardless. What’s more, what hasn’t been mentioned is the Greek state companies – like the Greek railways – which also issued their bonds under English law. There’s another E100bn in debt sitting there which the Greek government is also on the hook for and everyone is staying very…quiet…about and hoping it will go away.
If it were just Greece, this wouldn’t be so bad, but it isn’t. Spain, Portugal and Italy are in the same boat – they can’t pay their debts. It’s looking like Ireland may need another bailout despite introducing the stringent austerity measures demanded of them. And the stronger Eurozone nations? Well, lets look at some numbers, shall we?
• Take Belgium; With a GDP of E467bn, they have public sector debt of E466bn, and when the bank Dexia went under last year the government bailed it out by underwriting another E116bn of bad debt not counting contigent liabilities.
• When Greece was bailed out, we were told that Greek debt would peak at 120% of GDP in five years and then start to fall. It's already there.
• Portuguese public sector debt is 140% of GDP and rising.
• In order to offset outstanding liabilities falling due within the next few years the ECB will need to print at least an additional 2 trillion Euros.
• French and German banks are estimated to have over E200bn in unfunded liabilities and, unlike the British, the French and Germans haven’t even started recapitalising their banks yet.
• According to the European central bank, Eurozone banks are E2.78trn short of the capital required to make them safe in the event of future financial shocks.
• One third of Eurozone banks cannot meet even 'tier 3' funding requirements of 3% of liability.
• The ECB is accepting from Eurozone banks as collateral for loans those self-same dodgy derivatives and Eurozone debts which are unpayable, and it is accepting them at face value thereby saddling the EU taxpayers with the liabilities.
Across the Eurozone, total net debt liabilities are estimated to be well in excess of ten trillion Euros. And that brings us back to London, because thanks to unlimted rehypothecation of assets – i.e. the debts held by London institutions - in the shadow banking system is it estimated that anything up to another eight trillion Euros in liabilities is sitting there off balance sheet and unreported.
If you stop and think about it, suddenly everything George Osborne is doing makes sense. He has to buy time for the London financial services industry to unwind its Eurozone position, as if the Euro splits then it will take London with it and for as long as the government of the UK is reliant on the financial services industry for 40% of tax revenues that’s just not going to be something to take risks over. Similarly if London goes under it’ll take the Eurozone with it, so he can’t push for the stupidity taxation on the city. Like King Lear and his fool clinging to each other for fear of the tempest which rages about them, London and the Eurozone are inextricably linked until the entire sorry situation can be unwound. The colossal, unfunded liabilities of the Eurozone and the financial services industry. So Osborne drips liquidity into the system; a bit of tax here, a bit of QE there, a donation to the IMF to prop the Euro up for another day, buying time for the city to get out of the hole it dug for itself.
There aren’t many ways out of this. A decade of slow – if any – growth, cuts and austerity may be the best solution. Monetising debt, by which I mean printing money and buying the debts and then just forgetting about them, is another route being pursued. This has the side-effect of inflation which might reduce the value of your savings but at least it means they won’t evaporate when your bank goes under and it’s found all your money not only now belongs to someone else, but in same cases never even existed.
Globally, things look the same. The distant flushing noise you hear from the East is Chinas’ growth estimates vanishing down the lavatory as their construction sector grinds to a halt; 30-40%% of Chinese government tax revenues are generated by the construction sector. India is relying on the monsoon this year being a particularly good one to restore their economy to growth. The US is US$16trn in debt and that figure has risen 16% in the last 24 months. If you want a prediction, it’s that the US will announce a further QE programme of between 5-700bn at some point between July and September this year. Global GDP is estimated at US$59trn. Global debt liabilities are estimated at US$220trn.
As some southern European countries attempt to ban large transactions taking place in cash to clamp down on tax avoidance (the Spanish are talking about introducing a law that any cash transaction of over E1,000 must be carried out in the presence of a tax inspector), people are shifting from money to barter as globally the financial system strains. From this town in Greece where people have given up on money and gone back to barter, to China buying US21bn in oil from Iran with a combination of goods, services and gold rather than actual money.
Economists – especially ones who aren’t going to lose their jobs if they turn out to be wrong - have said that the way out of the credit crisis is, ultimately, to increase the money supply. Or maybe we can ‘abandon austerity and go for growth’. You know, the next time someone says that, point out that the UK has taken on liabilities of almost two trillion quid in the last decade or so and printed two hundred and seventy five billion more. You might ask them, given that this printing and borrowing doesn't seem to have resulted in all that much growth, just how much more we need to borrow before it starts working. Alternatively, just punch them in the face. It’ll be quicker.
In the light off all that increase in debt and printing, the best performing asset class since the start of 2012 has been bullion.
Hang on, wasn’t I saying that would happen last August? Why, yes. Yes I was. I do hope you were listening.
Some people have said that the way for the UK to cut the deficit and still avoid state spending cuts is for the rich to pay their 'fair share'. To put that into perspective, if Britain's two richest men (Lakshmi Mittal and Alisher Usmanov) were to write cheques to the treasury for their entire net worth tomorrow, that'd just about cover the deficit and cuts until the middle of June. If everyone in the top 1,000 richest people in the UK were taxed every single penny they own, it'd get us until about this time next year. Who, precisely, are we supposed to tax 'fairly' after that? It's no more a long-term solution than printing money is.
Economically, the current level of state debt, liabilities and spending are not sustainable - and the one thing you can say with absolute certainty about things which are not sustainable is that they will not be sustained.
Just sayin'.
