Thursday, 5 March 2009

Never mind the quantitative, feel the ...

So, the merry-go-round has been started up in the great funfair of the vanities that is current economic policy. The government is printing £75billion of monopoly money now with up to another £75billion when this lot fails to achieve anything, so we can make that next month then. This is hailed by the BBC as "Bank to pump £75billion into economy". Doesn't that sound nice? We all need more money in these difficult times, how very lovely of the Bank of England to give us all so much to play with. Super.

It reminded me of a divorce case I dealt with twenty-odd years ago in which the the wife was giving evidence about how much money she needed. After describing her need for a house, a car, two televisions, long finger nails and a small poodle was was being cross-examined about how her husband could be expected to find so much money out of his small shop business. Her reply was "he's hasn't just got the shop he's got a company". Indeed he had, the shop operated through a company with £100 of share capital (ironically owned equally by husband and wife). She honestly thought that a company could just make money appear as if by magic regardless of how much went through the till. "Bank to pump £75billion into economy" has the same ring to it. It gives the impression that this massive pot of cash is going to appear out of thin air and be unleashed for the greater benefit.

Of course the company of the divorcing husband might have been able to raise a loan and, in turn, lend that sum to the husband to pay for the wife's poodle, but there would be nothing magical about it. The company would have to repay the loan with interest and the husband would have to repay the company. No magic new money, just borrowed money that will be a net drain on resources unless it can be put to a profitable use. Such borrowed money is new money for the people who borrow it but the crucial point is that it does not increase their net wealth. It puts, say, £100,000 in the credit column but puts £100,000 in the debit column. As interest accrues further debit entries appear and their net wealth diminishes unless there are corresponding increases in the credit column. That is the whole point about credit and wealth. If you borrow money and make it work for you so that you make a greater gain than the amount of interest you have to pay, then you genuinely create new wealth from that money. But if you just spend it on things that get consumed you diminish your wealth by borrowing. Our pitiful government has defined its own profligate spending as "investment" for the last decade, but that doesn't mean it was investment any more than I might go to the supermarket and say I have invested in a pound of cheese.

The contrast between the divorcing couple and the Bank of England is that the latter can just magic new money out of thin air. There is no need to print a single extra £10 note to do this, all they have to do is press some buttons on a computer and "kerching" they have an extra £75 billion appearing on a computer screen and credited to them. So, if Dodgy Mortgages PLC needs £10billion to lend to individuals and businesses the Bank of England can say "We'll give you £10billion for the mortgages loans you made in 2006 and which are now defaulting." A piece of paper is signed, the Bank of England is now the proud owner of the right to receive payments of interest and capital on loans that aren't worth the paper they are printed on and Dodgy Mortgages PLC is free of those bad debts and has a clean £10billion ready to advance to the waiting hordes. In reality all that has happened is that the bad debts are still in existence but an extra £10billion of cash is now floating around.

The problem with doing this is that there has been no increase in real wealth, just an increase in the money supply. The concept of wealth is at the heart of understanding what money is. Money is just a means of measuring wealth. If I own a house, a car, furniture, books, paintings, sculptures and a set of golf clubs, it is those things which represent my wealth. Whether you value them at £100,000 or £2million, my wealth is exactly the same, all that has changed is the nominal value attributed to each pound. And how do we know the current nominal value of a pound? We take the total wealth in the country and divide it by the number of pounds in circulation (OK, there's rather more to it than that, but it's a good rough guide). Increase the number of pounds in circulation without increasing the assets they represent and each pound represents a smaller proportion of real value, in other words you need more pounds to buy each thing. Prices go up. You have inflation.

One problem with inflation is that it makes ordinary everyday things unaffordable for the least well-off. A great many people spend all their income on the basics - housing, water, food, clothing and fuel. Increase the number of pounds they have to pay without also increasing their income and they have to forgo basics. Not nice. A situation to be avoided if possible.

Throw lots more money into circulation and you risk creating huge inflation of the type seen currently in Zimbabwe. So why, one might ask, is the government following that path now? It seems to me there are two reasons.

The first is to create inflation so that current debts (measured in pounds) represent a lower proportion of national wealth. If you owe £100,000, you owe £100,000. If today £100,000 represents the price of a Rolls Royce and tomorrow it represents the price of a Scoda, your debt falls in real value despite being the same number of pounds. This helps you as a borrower and shafts the person to whom you owe money, which in many instances is ultimately an overseas bank or investor. As always, if something looks too good to be true, it is. Domestic inflation hurts the poorest first last and all the time. That is a high risk for any government to take merely to reduce the real value of debts measured in pounds, and it does nothing at all to debts measured in other currencies.

The second is to provide a stimulus to the economy, primarily by making more money available for the banks to lend. At the moment it is asserted that credit has dried up causing housing sales and high street sales to stagnate, and causing businesses to be short of both working overdrafts and loans to fund investment in expansion. If this stimulus works, real wealth could increase thereby negating the inflationary effect of there being most pounds sloshing about. After all, an increase of 5% in the number of pounds in circulation doesn't matter if wealth increases by 5%, the two balance themselves out. So, if you increase money supply by 5% first and this causes a 5% increase in wealth you will reach a balance even if there is a time lag between the two.

To my mind a number of factors point towards inflation being a greater likelihood than a stimulation of economic growth.

First, there is already an inflationary element in the economy because assets have been overvalued for years, especially housing. Our real wealth has been worth far fewer pounds than it purported to be. While the money supply seemed to be balanced with asset values at their over-stated level, as that level becomes more realistic we will have a surfeit of pounds. To throw more pounds into the national pot increases the prospect of inflation in areas other than housing.

Secondly, there are excessive levels of personal debt on credit cards and through second mortgages which will be repaid through cutting back on discretionary spending. Much of the boom economy was built on spending funded by unaffordable credit, that will end. In addition, those burdened with hefty liabilities on credit cards or other loans will repay those debts by not spending at restaurants, clothing shops, electrical good suppliers and all the rest (or they will go into insolvency). The scope for boosting personal spending by boosting credit is severely limited. Shops selling the optional extras of life are likely to be facing a tough time no matter how much extra cash is in circulation.

Thirdly, the stock market falls over the last year have wiped a third or more off the value of many investment funds. The pressure to save more will be strong. Although historically low rates of interest provide a disincentive to save because the value of what you have saved actually falls when you receive 1% interest and general inflation is above 1%, the fact that existing savings have been decimated requires many to do what they can to build up the funds they will need later in life. This, again, acts to restrict the amount people feel able to spend.

Fourthly, borrowing to buy a house or flat will only be done by those who really need to. The housing market is, it seems to me, still grossly inflated and has a long way to fall to get to realistic levels. Even if it only another 5% (highly wishful thinking, in my view) that is still a £10,000 loss on a £200,000 property; no sensible person will take that on unless they have no other option.

Fifthly, the banks have to be more stringent in their lending criteria than they have been for many years otherwise they will just build up another massive portfolio of bad debt. This affects not just lending for house purchase but for everything else as well. Since they must lend less and with greater profit margins, the scope for a consumer-led recovery is reduced further.

Sixthly, lending to businesses is bound to be tighter as consumer spending falls because potential business borrowers will have to explain how they will be exempt from the downturn in spending. At the moment we hear government ministers complaining that businesses can't get the credit they need to keep going, but this assumes they will be able to keep going even if they get the credit they seek. That is quite unrealistic. Many businesses that were a good risk to the banks a few years ago are now a busted flush.

Seventhly, higher taxes will have to bite within the next year or two because the government has borrowed so much money to throw at the problem. As and when the recession bottoms-out, the higher taxes will have to kick-in, thereby lengthening the time before consumer spending can return to anything like the levels of a couple of years ago.

All these points, and there are probably many more, suggest that it is unrealistic to hope we will spend our way out of this hole. Yet again the government has not had the courage to speak the one unassailable truth in all this horrid mess (and, to be fair, the Conservatives also don't have the guts to say it). For years and years we have been living beyond our means and pretending that we have real wealth and substantial spending power when the reality is that we are nothing like as wealthy as we thought.

We have been living a lie and any attempt to resuscitate that lie by trying to stimulate both borrowing and spending is extremely dangerous. Either it will not work at all, in which case the result is massive wasted expenditure; or it will work in the short term, in which case the problem just becomes greater sometime in the future.

And the greatest error is to think there is a solution other than allowing the problem to work its way out in its own good time. If ever "do nothing" was the right approach, it is now.


1 comment:

The Great Simpleton said...

Your story about the woman thinking a company could just magic money reminded me about an equally ignorant understanding of business.

My father took a tenancy on a pub in the late 60's. He was amazed to find how many people, especially customers, thought he was rich because all the cash that went over the bar went straight in to his pocket. All they could do was equate cash with profit, they couldn't get round their heads round the costs of doing business.

Sadly that ignorance still pervades in some quarters - parliament appearing to be one of them.