Strategic thinking void

When the incoming UK government announced severe cuts and tax rises all group were affected, including the police. Yet with such cuts and tax hikes it is rather obvious - no benefit of hindsight needed - to realise that strikes and public unrest are very likely. When Margaret Thatcher decided to take carry out deep reforms over 30 years she excluded from cuts the police. In fact she improved the police terms and conditions of their employment. Incidentally a few weeks ago the Poland's government showed the same approach to reforms: giving a rather raw deal to almost everybody but improving the police's.

So there was little surprise that when the looting erupted in London and other towns last summer, the police was quite apathetic to react. It looked almost ostentatious as if they were taking their time. As a result the scale of disorder might even surprised the police but it proved a vital point to the government. The point was that the police was important and they better thought twice before they made any further cuts. It is unlikely that it was the police officers conspiracy. It looked it was a manifestation of self-defence, that may got out of hand a bit.

Now the government is making yet another mistake. It is going into confrontation with trade unions. Historically strike were very unpopular in Britain and the public tend to blame the striking folk more than the government for the inconvenience. But this approach was a result of a judgement on the situation that to many in the society seemed fair. In the past the strikers had a good deal and generally were living on the state subsidies, like heavy industry workers over 30 years ago. This stereotype was later transferred onto all public sector workers.

But times changed. No the group that is now being subsidised heavily and most is the financial industry. All taxpayers have to chip in to subsidise the City to much higher degree than heavy industry 3 - 4 decades ago. And the remuneration of financiers is much higher than of the heavy industry workers. The public sector finances are in such a huge mess because the government has to over borrow in order keep the banks afloat. This all is a source of protest amongst all those who are affected by the government spending cuts and tax rises. "We are all in it together" apart from the financial industry who can only carry on their old ways doing business due to the fact that "we are all in it together" keep subsidising them.

Therefore now the public is likely to have a lot of sympathy for the workers going on strike. And it is an irony that trade union are actually fighting for more free market, i.e. cutting subsidies to the financial sector. The striking workers do not want anything more. They want to keep what they have got which, compared to heavily subsidised financial industry, is not that much. The government is likely to make a misjudgement: ordinary taxpayers are likely to accept the strikes as a protest against them subsiding the financial industry. And this can only fuel even more unrest and make other groups join in.

With disaffected unemployed youth that have little prospects as even they find the job they will have to start paying taxes to subsidise the financial industry, not exactly happy police, radicalised trade unionists and public sector workers and the general public who frankly have enough to keep subsidising the banks, the government should think of contingencies for a long period of discontent. Cynics say that some already are ready for it: resign and join the City (i.e. continue to live at taxpayers expense).

"Credit easing": another good money thrown after bad

When politicians start doing something right you can be sure that the situation is serious. This cynical comment - sometimes quite unfair - seems to be true this time. The British Finance Minister (the Chancellor of the Exchequer), George Osborne, plans for a "credit easing" programme for small companies worth £20 bn (possibly up to £40 bn). The previous money expansion programmes, i.e. banks' recapitalisation and rounds of quantitative easing, failed to jump start the economy. The reason was simple and obvious before these actions: no benefit of hindsight. Having depleted the banks reserves by running a giant pyramid scheme (effectively banks defrauded the reserves), the banks were holding on to new money to keep them afloat. In 2008 it was already obvious that if the government wanted to jump start the economy, it must have set up an altarnative system of putting new money into economy AND circulating them outside the mainstream financial system.

After over three years the government seems to have understood the first part. Hence the decision to start "credit easing" for small companies. It is an introduction of new money into economy effectively bypassing the banks. The amount mentioned is not staggering. It is £20 bn, but it can be very effective. Typically in a healthy functioning economy, with a healthy financial system, would have multiplied this narrow money in circulation into £140 - £200 bn broad money. This could have jump-started the economy.

However contrary to a recommendation given to the House of Commons Treasury Committee, the government does not provide any mechanism to circulate these £20 bn in the economy safely, generating new credits from the initial injection, "easing". Once businesses start getting credit through "credit easing" these money will end up in the financial system, it will be cashed for all sorts of toxic waste that the financial system has generated for years and keeps generating them or in the reserves. It will not be relent. It will be another way of subsidising the banks. As a result £20 bn will be expanded in a minimal way, if at all. No doubt it will help some struggling small businesses. But there is a very high risk that from the economic perspective it will be a good money, with the best of intentions, thrown after bad money.

Sometimes a half of good solution is a bad solution: "credit easing" seems to be falling into this category. It is likely that in six months time or so the government will be wondering why the programme failed. But is it not obvious now?

Budget. What budget?

It is not that long ago when the Chancellor of the Exchequer (the British Finance Minister), Gordon Brown, was preaching the virtues of a balanced budget. In fact this was a commonly accepted wisdom: in a period covering up and down ("boom and bust") of economic cycles governments should balance their budgets. They should have neither surplus nor be in debt. There was a debate how it can be achieved. One approach was that a surplus produced during good times is saved and then used in bad times. The government is never in debt and any surplus is kept as a reserve for bad times. The opposite approach is that during bad times the government gets into debt which is then paid back during good times. The practical solution would be somewhere in between. Precisely where, can be the subject of pragmatic arguments and philosophical debates. What had never been put into question was the entire concept as it clearly makes sense.

After the outbreak of the current financial crisis when governments had spent massive amounts of monies to subsidise the collapsing financial industry, the concept of the balanced budget remains forgotten. Now the real issue is the maximum level of debt governments can sustain in servicing it. In practice it means that governments would remain in maximum permanent debt paying maximum amounts in interest and service payments to the financial industry. And whenever the capacity of repayment appears the debt will be increased, rather than repaid, so the maximum level of permanent interest and service payments to the banks is maintained. Such increase of debt can be achieved through various mechanisms like additional bank's bailout or a downgrade in the credit rating. This is a classic strategy that loan sharks use against their victims: this is how the financial industry - with politicians as conduits - treats the taxpayers now.

This current level of governments debt is a direct result of banks' bailouts. These bailouts broke the traditional economic cycle of "boom and bust". Indeed Gordon Brown's claim that "boom and bust" in the UK was abolished seems correct. But not in a way that Mr Brown would have hoped: the UK ended up in a state of permanent, or at least very long term, "bust" state. When the British government rescued banks to the tune of £65 billion (of direct costs) in 2008 it was not just about £65 billion, a massive amount of cash as it was. These £65 billion ended up in banks coffers filling up the liquidity hole which was created by the banks running a giant pyramid scheme. Banks did not start lending and it was obvious that they could not have started doing so. So £65 billion did not end up in real economy but in the banking system securing interbanking transactions against toxic waste which were generated by the pyramid process. Needless to say these £65 billion generously helped to fund the financiers remuneration.

This £65 billion debt is not just a normal government debt as it would have been if this money had been spent in the economy through tax cuts or public spending. If the banking system was relatively healthy (i.e. did not require rescuing and was not such a pyramid as it is) and the government borrowed additional £65 billion, to fund tax cuts or to spend on public investment programme to stimulate the economy, then through the healthy banking system credit creation cycle this £65 billion would have been multiplied seven to ten fold. Therefore the debt directly generated to rescue the banks in the UK in real economic terms cannot be considered as additional £65 billions on the government balance sheet but as £455 billion to £650 billion lost opportunity costs of the real economy.

Bailouts, such as one in the UK, happened in the US and the entire eurozone. It is economic value is not in hundreds of billions of euros or dollars, but in serious trillions. And it keeps growing. The financial system which was turned into a classic case of a pyramid scheme (in legal and technical terms) and which the governments decided to support, is killing off the real economy. The idea of a balanced budget is unlikely to come back soon.

Debt Dynamics

Debt, in itself, generates more debt by attracting interest. At present it appears that the current level of debt, in Eurozone - and in almost all western economies including the US' - attracts more interest than the repayments generated through economic growth (collected as taxes). There is no doubt that recovering from the current crisis will require debt write offs. But how much would it be on a global scale? It makes a significant difference if, for example, 20% of debt on the banks' books (globally) has to be written off for the economy to recover, or 99%. And it is actually likely to be far closer to 99% than 20%. And then there is a question who will be on a receiving end of such write offs: basically who is going to lose loads of money. As the history shows the answer to this question may make the difference between peace and war.

But debt write off is not such a simple process. If it happens it will be a default. Even if voluntary the courts are likely to rule that it is a credit event. This, in turn, will trigger CDS' payouts (sometimes referred to wrongly as insurance against a default; in fact these are the bets put that default would happen). Due to the nature of CDS' these payouts may actually be greater than the underlying debt, value of default (since it is possible to buy CDS' on a particular default event exceeding the value of the debt). So from financial system perspective, debt write offs may trigger liabilities much greater than debt itself: i.e. the cumulative value of CDS' payouts may exceed, by far, the value of written off debt (some estimates go into hundreds of trillions or even quadrillions of dollars). And who is going to pay it? The guarantee will come back again on the taxpayers doorstep.

The current credit creation mechanism in the banking system (lending with loan to deposit ratio greater than 100%) is also unsustainable. Such mechanism needs financial innovations, like collateralising and rolling over of debt, to be operated. The unsustainability of this mechanism is such - it is basically a pyramid scheme mechanism - that even if a sufficient global debt reduction is done (even a total 100% write off), and somehow CDS' liabilities are written off too, the debt write off strategy will not work anyway: the world will be back in debt and soon.

The new debt generated by credit creation with loan to deposit ratio greater than 100% will very quickly (at exponential, intractable, pace to be mathematically precise) return to pre write-off level. But a credit creation process cannot be stopped totally without killing the economy altogether. This is actually what is happening to a large extent now: banks lend very little to genuine businesses. The solution to such quagmire is given by basic mathematics (this is what the work on this blog has been all about): after making sufficient write-offs, lending with loan to deposit ratio (system-wise) greater than 100% should be banned explicitly. Thus far it is banned implicitly as pyramid schemes are banned, but financial institutions ignore it. In practice ledning with loan to deposit ratio greater than 86.5% (or even less) should be banned. This is not a guarantee of a solution to all economic and financial system problems giving a speedy recovery, but without it no solution is possible. The world will keep getting into debt deeper and deeper.

The quagmire of the current situation is that, from technical and legal perspective, for some years (at least a decade but most likely much longer) the financial institutions have been running a massive global pyramid scheme. What we have been observing for the last 3 years is a typical ongoing collapse of the pyramid. It looks exactly the same as Albanian pyramids of 1996 - 1997. The fact is that the financial system - with the support of politicians - is determined to maintain such a massive pyramid scheme. In practice it means more collapses and bailouts and never ending debt for the taxpayers to keep such a loan shark business going.

Lord Lawson: Greeks should vote "no" in the referendum

Today at lunchtime, Lord Lawson (a UK Chancellor of the Exchequer between 1983 and 1989) has given a lecture at the National Liberal Club in London. The title, put in form of a question was: "Is the Eurozone crisis a threat to global stability?" It was an excellent review of many aspects of the causes and mechanics of the ongoing financial crisis from macroeconomics perspective.

After the lecture, during a question session Lord Lawson was asked how he would have advised the Greeks to vote in the referendum (if there is one) on accepting the last week's financial bailout deal. His answer was unequivocal "no". Lord Lawson did not answer a question whether he expected colonels back in power in Athens by this Christmas.

Greek recovery: Greece doing Iceland?

It is impossible to say whether Greece will (or will not) leave the euro. Let's leave it to fortunetellers. However the rest of Eurozone seems mortified to the point that they decided to parade and grotesquely admonish Greek Prime Minister Papandreou in front of G20 leaders. Cannes, the European film capital, was indeed the fitting location for this tragic farce.

It may well be the case that Germany might not be able to leave euro themselves orderly before the whole thing starts crumbling. So the Greeks get bullied by their European friends. They are told that they will be better off by accepting a massive austerity programme than by defaulting and basically starting from scratch as a bankrupt country. Public spending control and cuts is a good idea. But the Greeks are not the Germans. And even the last time round when Germany went through economic hardship, in the 1920's and 1930's, it produced the leader whose idea about European integration was rather unorthodox.

Greece is told that if they get half of their debt written off, accept a massive economic hardship for a decade, by the 2020 they will still be... 120% in debt to their GDP. It is unsustainable. By comparison the current Italy's debt to GDP is, surprise, surprise, 120% and is considered as unsustainable, And Greeks are meant to approach this level from the other side. Therefore, frankly, Greeks are on a receiving end of a lunatic proposition. The fact that the European leaders do not see this unreal side of their actions does not say much about them. It is actually very worrying.

The concept of bankruptcy was invented and defined in law for a reason. It is possible to reach a point when nothing works better for a debtor than accepting the insolvency and starting with a clean sheet.

Greeks can also take Iceland as an example: it was really the first and the only country that went bust in this crisis. They admitted the game was up. Iceland started negotiated hard with creditors. They have had their national interest in mind: first come Icelanders and then they can pay others. And quite rightly so: this is what sovereign nations, and their governments, are all about and creditors to sovereign nations know exactly that when they lend money.

Not surprisingly although Iceland is still heavily criticised for their actions, it is reviving pretty well. And less than three years ago it reduced its financial and state institutions to a basket case. However the common sense and survival instinct prevailed and Iceland is now where it is. Actually not bad. Greece can recover fast too: if Greece default on all of their debt, by next year, they will be running on the budget surplus, such is the current burden of interest. Take example from Iceland is no-brainer. Besides country bankruptcies are quite common in history so really the fuss, the opposition about the Greeks going bankrupt is about effectively enslaving them, to make them keep paying as much money as they can be squeezed for till the end of the world, and possibly one day longer. A classic loan shark strategy.

There is a side show to the prospect of Greece defaulting that no politician or commentator is taking about. Typically the most important and interesting things are those which are not talked about. Greek debt is supposed to have been "insured" by CDS'. So there should be no problem with Greek default, should it? It does not appear so. Despite the fact that CDS' are sometimes described as insurance against defaults, they are not. (As clearly they cannot bear the costs of Greece defaulting.) They are simply tools of market speculation with heavily misleading financial information about them: financial "weapon of mass destruction" as Warren Buffett called them. They epitomise the pathology of the financial system. Greece has many clever people in finance and wealthy individuals. Therefore it seems quite reasonable to assume that many of them, having common sense and possibly some inside inklings, bought a lot of CDS' betting that Greece would eventually default. They had plenty of money: apart from their own, thus far European bailouts were generous. Technically their CDS' value may actually exceed the Greek debt itself. Many time over. Therefore it is not inconceivable that, even if Greece do not benefit itself financially from the default, the default may actually produce a number of Greek millionaires or even billionaires. Greeks have an upper hand? This is what modern innovative finance is all about. Only if you know how to play it right.