The upcoming Lloyds rights issue is in fact quite simple. They are giving shareholders the right to buy ~50p worth of new shares for each of the currently existing shares they hold. The new shares will be offered at a discount, but their price has not yet been set, so, obviously, you cannot yet determine how many new shares you can buy. But you’ve been told, albeit somewhat cryptically, what you need to know right now: if you want to take up your rights, you’re going to need to find 50p for each share you own when the rights issue process starts on 20th November. [Summary paragraph added 8:45am 4/11/09].

But is it just me or is the organisation and presentation of this rights issue more complicated than it needs to be? [Reworded 8:45am 4/11/09].

I quote in full section 10 of Lloyds’ announcement of its rights issue:

“10 Share Subdivision

Under the Companies Act, it is not permissible for a company to issue shares at a discount to their nominal value, which, in respect of the Existing Ordinary Shares is currently 25 pence per share. It is proposed that the Company carries out the Share Subdivision which will reduce the nominal value to 10 pence per share. This provides the Company and the Joint Bookrunners with greater certainty that the Issue Price will be able to be set at a 38 per cent. to 42 per cent. discount to TERP [the Theoretical Ex-rights Price, which itself depends on the number of new shares being issued, so a bit of algebra is needed to determine the issue price for 38-40% discount based on the current trading price of the existing shares] irrespective of market conditions. The Board believes that the Share Subdivision also provides the Company access to the best available underwriting structure and terms. Although no decision has currently been made as to the Issue Price, in no circumstances will the Issue Price be below 15 pence. As noted in paragraph 8 of this letter, the Issue Price is expected to be announced on 24 November 2009, two days before the General Meeting. The Proposals are conditional on, amongst other things, the completion of the Share Subdivision.

It is proposed that, pursuant to the Share Subdivision, each existing Ordinary Share of 25 pence in issue at the close of business on the date of the General Meeting will be subdivided into one ordinary share of 10 pence in the capital of the Company (a “10p Ordinary Share”) and one deferred share of 15 pence in the capital of the company (a “Deferred Share”). The purpose of the issue of Deferred Shares is to ensure that the reduction in the nominal value of the Ordinary Shares does not result in a reduction in the capital of the Company.

Each Ordinary Shareholder’s proportionate interest in the Company’s issued ordinary share capital will remain unchanged as a result of the Share Subdivision. Aside from the change in nominal value, the rights attaching to 10p Ordinary Shares (including voting and dividend rights and rights on a return of capital) will be identical in all respects to those of existing Ordinary Shares. No new share certificates will be issued in respect of the 10p Ordinary Shares as existing share certificates for existing Ordinary Shares will remain valid in respect of the same number of 10p Ordinary Shares arising from the Share Subdivision. The number of Ordinary Shares of the Company listed on the Official List and admitted to trading on the London Stock Exchange’s main market for listed securities shall not change as a result of the Share Subdivision. The Share Subdivision will not affect the Group’s or the Company’s net assets. Consequently, the market price of a 10p Ordinary Share immediately after completion of the Share Subdivision should, theoretically, be the same as the market price of an Ordinary Share immediately prior to the Share Subdivision.

In addition, it is proposed that, pursuant to the Share Subdivision and as required by Article 3.1.4(i) of the Articles of Association, each existing Limited Voting Share of 25 pence in issue at the close of business on the date of the General Meeting will be subdivided into one limited voting share of 10 pence (a “10p Limited Voting Share”) and one Deferred Share. Aside from the change in nominal value, the rights attaching to 10p Limited Voting Shares will be identical in all respects to those of existing Limited Voting Shares. No new share certificates will be issued in respect of the 10p Limited Voting Shares as existing share certificates for existing Limited Voting Shares will remain valid in respect of the same number of 10p Limited Voting Shares arising from the Share Subdivision.

The Deferred Shares created on the Share Subdivision becoming effective will have no voting or dividend rights and, on a return of capital on a winding up of the Company, will have the right to receive the amount paid up thereon only after Ordinary Shareholders have received, in aggregate, any amounts paid up thereon plus £10 million per Ordinary Share.

No share certificates will be issued in respect of the Deferred Shares, nor will CREST accounts of shareholders be credited in respect of any entitlement to Deferred Shares, nor will they be admitted to the Official List or to trading on the London Stock Exchange or any other investment exchange. The Deferred Shares shall not be transferable at any time, other than with the prior written consent of the Directors. The rights attaching to, and restrictions upon, the Deferred Shares are set out in Resolution 6.

At the appropriate time, the Company may repurchase the Deferred Shares, make an application to the High Court for the Deferred Shares to be cancelled, or cancel, or seek the surrender of the Deferred Shares using such other lawful means as the Directors may determine.”

Got that? You’ll be tested on it later!

In fact, all section 10 says is that to get round some stupid rule, and in case Lloyds shares fall before the rights issue completes, we’re all going to be issued with “deferred shares”. These are totally worthless. I just hope they don’t actually show on my trading account, cluttering up the screen and statements.

Frankly, who cares about the nominal value of shares? And, if the rule that companies can’t issue new shares at below the nominal value of existing shares is so easily circumvented, does it really have any point? Maybe the law could simply be changed to add “unless approved at an AGM”.

I’d rather the army of accountants and company lawyers running large companies were employed making sure the business doesn’t screw up, not worrying about worthless deferred shares. Someone was obviously paid to write the paragraph that ensures the deferred shares are worthless. On the other hand, maybe it was worth it for the amusement value. I like it so much I’ll quote it again, this time with a bit of emphasis:

“The Deferred Shares created on the Share Subdivision becoming effective will have no voting or dividend rights and, on a return of capital on a winding up of the Company, will have the right to receive the amount paid up thereon only after Ordinary Shareholders have received, in aggregate, any amounts paid up thereon plus £10 million per Ordinary Share.”

Perhaps they should index that £10 million to RPI. We might experience hyperinflation.

Lloyds is also waiting till the last minute before telling us what the issue price of the new shares will be, in case the short-sellers get their teeth into the situation. Actually I don’t care very much. What I want to know is how much I’m going to have to put in for each share I own. Then I can calculate the total amount I need to find. Shareholders are being asked for about 50p per share they own at the record date for the issue (20th November), calculated by dividing the amount to be raised (£13.5bn) by the number of shares in circulation at the moment (just over 27bn, a number which won’t change materially over the next couple of weeks). Lloyds’ announcement could easily have included the exact amount as a headline (I haven’t read all 200,000 pages of the documents they’ve issued today).

Rights issues remain dysfunctional as I explored here, here and here around 18 months ago (when HBoS was passing a hat around, ironically enough). All that’s been done is to try to speed the rights issue process up, which introduces new problems: the regulators haven’t speeded up the process of moving money about, and the post, for obvious reasons, is even less reliable right now (let’s hope we can all exercise our rights online or by telephone, eh?). As I said in my previous posts on this topic, it must be possible to devise a way of raising funds from shareholders that isn’t vulnerable to attack by short-sellers. Such a scheme would surely save on underwriting fees, for starters. Lloyds will only raise £13bn net from its £13.5bn rights issue. I can live with putting money into basically sound companies that need it, but it sticks in the craw that so much disappears in transaction costs (and in this case, a windfall tax in all but name). Especially when I’m not going to get any dividends for another 2 years!

When I used to frequent the Internet Chess Club they’d often use a message something like: “A hush descends as Grandmaster So-and-so enters the room.” Well, I feel the same reaction should greet Professor Nouriel Roubini’s entry into the discussion of the Great Carry Trade. It’s worth hanging on the Professor’s every word…

Roubini notes that:

“…while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades…”

Roubini, characteristically, worries most about the unwinding of the dollar carry trade.

I don’t know, I think there is a wrinkle here, which is that the US dollar can’t actually depreciate, not fully, anyway, because of China’s dollar peg. Therefore it hasn’t got so far to snap back in a panic. Sure, there can be some unwinding if the market suddenly perceives emerging markets to have become overvalued, more risky or growth less certain. This damping of the dollar’s movement makes dollar-funded carry trades less risky than they would be otherwise. This is not good, because it will allow bubbles to inflate even more than would otherwise be the case.

Roubini writes as if carry trading investors are making a currency gain by borrowing dollars, over and above emerging currency and other market movements. That’s only true if your accounting currency is neither dollars, nor, say, sterling, which is hardly appreciating nor going to appreciate against the dollar (and also appears to meet the criteria for a carry-trade funding currency). In fact, it’s only really true if your investors want euros or possibly yen at the end of the day, though one wonders why they don’t just borrow in those currencies to reduce the risk, if they believe a flight to safety would favour the dollar.

Since the dollar’s decline is primarily taking place against the euro, it follows, incidentally, that as I argued last time, the next phase of the game will be characterised by a eurozone trade deficit as well as a US and (not that it’s very significant to the rest of the world) a UK one.

Martin Wolf worries – to a very deferential Tech Ticker audience – that eventual US rate rises will have a dramatic effect. Sure. But – since interest rates do most of their work in curbing inflation through their effect on the foreign exchange rate – that simply means they won’t have to rise very much, doesn’t it? Of course, this will help to fuel further borrowing in US…

It might be worth comparing the dollar carry trade to the yen carry trade. The crucial difference is that the yen carry trade was/is inherently risky, because the yen has, for decades, been undervalued, given Japan’s persistent trade surplus (increasing again in 2009).

But we are in a fairly unusual situation of a reserve currency doomed to eventual decline: we can borrow cheaply in dollars because of its reserve status, but, as its status as a reserve currency diminishes, it will be seen to be fundamentally overvalued because of its trade position and the vast overhang of dollars already in foreign hands. So borrowing in dollars is something of a one-way bet – you don’t have to worry that your fortune has the Ponzi quality of depending on everyone else continuing to want to borrow in dollars. The dollar isn’t going to snap back up – notwithstanding a temporary recovery during the next major crisis – because its value is already being held up by central banks wanting to buy them. Rather, the dollar’s value can be expected to decline over time as it is replaced (by a mix) as the world’s reserve currency. Compared to the yen carry trade the dollar carry trade is a bargain, risk-wise. No wonder emerging market equities are breaking records!

Ambrose Evans-Pritchard is always an entertaining read. He writes today that the next crisis could be a Japanese default. But Japan’s trade surplus must make this unlikely. All they’ve got to do is divert some of Japan’s private savings to the public purse. Maybe a little easier said than done, of course, but there’s still plenty of scope. Of course, if they let their national debt rise from 2 to say 3 times GDP, it could start to get tricky to service…

Meanwhile, Peter Tasker worries about an asset bubble bursting in China. This seems closer to the mark. He compares China to Japan and notes that:

“If China continues to follow the Japanese template, the end of the dollar peg will be the trigger event [for the "final manic stage" of the bubble], setting off a Godzilla-sized credit binge.”

There also seem to me to be similarities with the Great Crash of 1929. We are in a fairly unusual situation of a reserve currency doomed to eventual decline, but it is not a unique situation. Didn’t the UK coming off the gold standard in 1925 convince investors that the dollar was the place to be? Blaming Churchill (who took the decision) is wrong-headed. The problem was that the peg existed in the first place, not that we came off it. It might be hitting the ground that does the damage, but the problem is trying to float in the air in the first place.

It seems to me the sooner China appreciates its currency the less painful it will be for everyone. Especially as, the longer Chinese economic growth exceeds that elsewhere, the bigger the relative size of its economy and the greater the imbalance caused by the undervaluation of its currency against the dollar. As I said when I started trying to get my head round all this, currency pegs are a very bad idea indeed. You may be able to market the buck, but you can’t buck the market.

As the nights were drawing in this time last year I detailed how the UK’s “bailout” of the banks is in fact the Mother Of All Stealth Taxes. Well, I underestimated the greed of our politicians.

In March this year the government had obviously not yet done a good enough job of convincing the world’s speculators that the UK financial system was safe. They therefore proposed an insurance scheme in case Lloyds’ losses on specific assets (some £260bn worth, mostly commercial property and mostly acquired when Lloyds took over HBoS) amounted to more than £25bn. For this insurance scheme Lloyds would be required to pay a notional amount of £15.6bn in shares as I described at the time.

I say the amount is notional, because no-one knows what the shares would have been worth in the future. Presumably existing shareholders think the shares are worth more than their current price or they would sell them. Furthermore, the price of the shares granted for the insurance scheme was set when the bank was in difficulty. Since pre-emption rights of existing shareholders (i.e. their right to buy shares on the same terms as the new investment in the bank) were not respected we have no way of knowing how many would have bought shares on the same terms as the UK’s Treasury was offering.

Since Lloyds would have to incur losses of £(25+15.6) = £40bn or so before it even broke even on the deal, their executives started looking into ways to make themselves strong enough to insure themselves against these potential losses. The situation is not straightforward, but Lloyds’ management must have considered that they could manage the assets to incur less than £40bn in losses.

Lloyds now believes it can raise enough money by selling new shares to existing shareholders and issuing some bonds (mandatorily convertible to shares in certain circumstances, I gather) to insure itself, which is, after all, a large part of what banks do.

But as is being widely reported, the Government is demanding a £2.5bn break fee. This has no logical justification whatsoever.

The febrile media reaction to the banks is typified by Dan Roberts in the Guardian. His commentary begins:

“Another day, another few billion pounds of our money is on its way to cheer up Britain’s banks. Today it was the turn of Lloyds to stick its hand out – indicating it wants an estimated £5bn to support its latest restructuring wheeze.”

and which descends into complete incoherence by the end:

“All in all, it’s like taking out house insurance during a fire, refusing to pay for it once the fire is out and sending the insurance company a bill for a new sprinkler system. The real irony is that behind all the complexity, the APS and this associated exit strategy boil down to something very recognisable to bankers by now: a credit derivative, the most toxic yet invented.”

In actual fact a capital raising by Lloyds is a welcome simplification of what looked like becoming a labyrinthinely complex relationship with the UK government. It’s not the role of the taxpayer to guarantee the dodgy property loans Lloyds inherited when it took over HBoS – when, we shouldn’t forget, the bank’s executives were denied the right to conduct thorough due diligence on behalf of Lloyds’ shareholders – so Lloyds raising capital itself so that it is strong enough to bear the potential losses of the assets now on its books represents a return to normality which pundits like Roberts should be welcoming.

What Roberts seems to object to is the government’s participation in the rights issue. But this is what happens when you’re a shareholder. The government will be better off compared to underwriting the losses on a £250bn dodgy loan portfolio. The cost to the Treasury of keeping its/our shareholding to 43% will be around £5bn whereas they could otherwise have had to pay out, we have to assume, perhaps somewhere around £25bn in insurance in return for increasing their holding in Lloyds from 43% to 62% according to calculations done back in March. Let’s be generous and assume ~20% of Lloyds raises £15bn when the taxpayers’ stake is eventually sold (valuing the whole bank at £75bn). Even then the taxpayer is at least £25bn – £5bn – £15bn = £5bn better off under the rights issue plan than writing the APS insurance, assuming £25bn losses, after excess.

The reader may ask why a deal being done at all. The answer is that obviously Lloyds’ management think they can keep losses somewhat lower, but the Treasury surely has to take a more cautious view – note that because of moral hazard, the level of losses could depend on whether or not they’re insured by the Treasury! Since the sensational news has just come through this morning that RBS is to exit the scheme as well, I suspect that all involved – particularly in government – have realised that the scheme is in fact unworkable. It distorts the two banks’ incentives so much that it is impossible for them to do their job of managing the bad debts.

But what of this £2.5bn fee? There are two sorts of justification. One is that the government “saved” Lloyds by proposing the APS. But if the government had done nothing either the whole banking system would have collapsed in March or the banks would have faced down the short-selling speculators and recovered (as Barclays did, its shares having risen 6-fold since then). I would have thought it was part of the normal responsibility of government paid for by all our taxes, not an optional extra, to ensure the existence of an orderly banking system.

Then there is the financial justification. Roberts suggests in his fire insurance analogy that:

“The catch here is that we haven’t been paid yet for providing this insurance when it was needed most (ie, during the crisis) and are having to haggle to get the premium paid retrospectively.”

For what the government deserves another £2.5bn (making them at least £7.5bn better off than before this latest deal) is not exactly clear. The point is the insurance scheme had a £25bn excess and was to run for 5 years, so Roberts’ fire insurance analogy is inappropriate – the insurance policy would have had to pay out nothing for at least the first couple of years. Logically, if there’s going to be a fee of this kind it should be offset against losses and writedowns to date against a scaled-back excess of ~£5bn, i.e. a fifth of £25bn, since about one of the 5 years will have passed since what I understand to be the baseline for the insurance policy of last December by the time the Lloyds fund-raising is complete. Furthermore, the FT this morning provides details of RBS’s losses to date on assets that would have entered the APS. I don’t know where such data for Lloyds could be found, but they are likely to be comparable. RBS has already absorbed losses of £23bn! Even if we take a figure of £15bn for Lloyds, then the loss after the excess is £10bn. The government pays 90%, so owe Lloyds £9bn. Fine. We’ll offset the £2.5bn against that amount!

The £2.5bn break fee is just an opportunistic tax, ultimately falling largely on UK pension funds. There’s no financial justification for this amount.

Lloyds shareholders are likely to be understandably aggrieved that the fee is much higher than the figure of £1-1.5bn that has been touted in the media for some time now. There has to be the suspicion that the government’s negotiators have ramped the price at the last minute. If so, this reeks – I would have thought government had a duty of fairness.

With another £13bn from a rights issue, Lloyds shares are in total worth around £40bn, tops, right now, so £2.5bn represents an arbitrary tax of at least (2.5/40)*100 = 6.25%. There is still an upside, but it’s not looking stellar. I gave a guesstimate earlier that, with a fair wind, Lloyds may eventually be worth £75bn or about double the value shares are currently trading at. But this might not be for 5-10 years. A lot of investors are going to consider that they can much more easily double their money in a “global return to growth” scenario by investing it in emerging markets – where the political risks these days seem no worse – instead of in the UK. Does the government want that to happen? Especially as they may want to sell a lot of bank shares in a few years!

I have owned Lloyds shares since I worked for the bank in the early 1990s. When I was given a few shares as part of my remuneration, I certainly wasn’t warned that the government would levy arbitrary taxes whenever the country’s finances hit a patch of turbulence.

Yesterday I explained why I consider that we’re in the midst of an era that could be termed the Great Imbalance. I go along with the the view apparently held by Nouriel Roubini that the so-called “Great Moderation” – the period of low inflation – is/was a mirage.

The point is that there is more than one tectonic shift taking place: low inflation has been caused, not by monetary conditions alone, but primarily by a historic reduction in the power of labour to raise wages and hence prices. Inequality is rising, full employment in developed countries is a half-forgotten phenomenon, jobs move around the world as part of globalisation; whereas the disruption of this supposedly happy state of affairs is caused by, well, trade imbalances.

A year ago I reported how the FT’s Martin Wolf had put his finger on the button (in fact, he’s written an entire book on the topic). Today I open my FT and see the argument outlined again, this time by Martin Feldstein in a piece titled “Why the renminbi has to rise to address imbalances”.

Feldstein argues that the US must increase household savings and China must increase domestic demand and “exchange rates must also adjust”. But this logical relationship is wrong. Exchange rates are the driver here. If the renminbi is allowed to rise against the dollar, American household savings and Chinese demand will adjust automatically.

Feldstein correctly notes that in the next phase of the Great Imbalance the euro will be drawn into the fray. The renminbi has dragged the dollar down. We’re going to start to see imports from Germany substituted by domestic Chinese (and American) products. (Europe will likely blame protectionism, and if they retaliate that would be a self-fulfilling diagnosis). Of course it will all be explained as due to the development of China, things they’re doing right that we’re doing wrong. The low dollar will be easily explained as a shift away from the dollar as a reserve currency since China will naturally hold more euros – a counterpart of its trade surplus with the region. But in fact all this will be the result of misaligned currency exchange rates!

Perhaps we should ask ourselves why China follows this policy when India does not. One problem India may avoid but China must face in the future is the sustainability of their industry. It’s all very well making things cheaply in external money terms, but we also have to consider whether they are being made efficiently in terms of physical real-world resources: labour, energy, the cost to the environment and so on. If these are being systematically mispriced – and it’s difficult to see how they could not be – then there will eventually be a reckoning, a crisis in China and a Great Rebalancing.

At the risk of oversimplifying, the difference with Japan, perhaps, is that, through successful industrial policies, Japan achieved export-led growth more by greater efficiency (such as quality) compared to the competition. This was sustainable even in the era when Japan was popularly termed “the Land of the Rising Yen”.

Feldstein’s conclusion is that:

“Fortunately, the Chinese economy is expanding rapidly and its growth is becoming less dependent on exports. When it has the confidence to allow the renminbi to rise, we will be on the path to reduced global imbalances.”

I don’t know. I think they need to start now, or maybe not to be starting from here at all. It seems to me that, in the real world, economic shifts are marked by destructive crises. We’ve probably got a few years before the wheels come off again. Or, if governments use the time wisely, maybe the train can yet be switched to a level track. Interesting times.

I was much taken by one of Larry Elliott’s pieces for the Guardian a couple of weeks back. Larry identified several eras: the Great Depression; the Great Compression, the period of strong growth and increasing equality after WWII; and the Great Moderation, the period of low inflation from the late 1990s to the early 2000s. We’re just ending the Great Recession (as this term was overused to describe 19th century episodes, I prefer “the Great Crunch”, which I think has a more modern flavour, but let’s go with Larry’s nomenclature today). I’d like to add to the mix the Great Inflation of the 1970s and 1980s. The question Larry asks is: What now? The Great Escape?

I’d like to argue that we’re likely to enter a period that we might call “the Great Imbalance”, reserving, on second thoughts, the title I’ve chosen – “the Great Carry Trade” – for the underlying cause. In fact, you could argue that the Great Moderation and the Great Recession are merely episodes in the history of the Great Imbalance.

Let’s first consider the causes of some of these various eras. Here’s my simplification of some complex phenomena:

• The Great Depression is so-called because growth stagnated in large part because of a breakdown in trade.

• After WWII trade resumed, but crucially without the Soviet Union and satellites, China and India. Larry’s Great Compression resulted from the growth in this era, together with, crucially, greater bargaining power on the part of workers, as collective bargaining reached its apogee. This combined with a squeeze on that critical resource, oil, to produce the Great Inflation.

• In 1989 the Berlin Wall came down. China and India have since become global players. This has locked in the reduction in workers’ power that occurred when unemployment resulted from the Great Inflation, permitting rapid non-inflationary growth – the Great Moderation.

Now, Larry writes that:

“One feature of the Great Moderation was the build-up in debt that allowed consumers in the US and Britain not just to live beyond their means, but to mop up the excess output from the low-cost factories in Asia. Debt is now being paid back, and it will continue to be paid back as the monetary and fiscal authorities withdraw the emergency stimulus packages of the past 12 months.”

But I’d argue that, far from “the build-up in debt” being a “feature” of the Great Moderation, it is a result of the fundamental cause of the Great Imbalance, that is of the Great Carry Trade.  And the Great Imbalance is not over, because international debt is not, in fact, being “paid back”.  And the Great Carry Trade itself has a cause: the false idol of export-led growth.

Larry also suggests that:

“The Great Moderation … could only be temporary, since its reliance on levels of debt that were only sustainable provided asset bubbles continued to inflate meant we were buying stability today at the expense of instability tomorrow. As such, Alan Greenspan created a housing bubble out of the wreckage of the dotcom bubble, thus disguising the structural problems in the US economy.”

I disagree: the cause of the Great Moderation phase of the Great Imbalance was not the debt, but globalisation. Larry is also writing in the UK, which somehow sidestepped a recession after the dotcom crash, so perhaps sees more stability than Stateside commentators. Regardless, I suggest that the conditions are already in place for the next bubble, because the underlying imbalance has not been addressed.

Larry titled his piece “Eastern promise holds little hope for west”. But why should this be? Growth based on trade is mutual – it’s not a zero-sum game. If I buy Chinese toys for pounds, the only way to zero out the transaction is for British products to be purchased with those pounds. The cash acts as a store of value. That’s the point of it.

But what’s happened is that the pounds and dollars used to purchase goods from China and other countries following a similar strategy has not been spent on imports from UK or US. The ramifications seem no less serious now than when I wrote nearly a year ago. Since then there’ve been a few developments:

• The worst recession for a generation.
• A fall in the value of the dollar (and pound) against the euro.
• A massive recovery in emerging markets in particular, fuelled by investment flows.

But no change in the value of the renminbi against the dollar.

So what’s going to happen?

Let’s consider trade first.  The eurozone was until recently in rough trade balance.  Now, though, the US trade imbalance with China (and others), which is an inevitable result of the currency pegs, will be shared by the eurozone.  Additionally, the eurozone will see a deteriorating trade position against the US (and UK).  In short, the next phase of the Great Imbalance will see the addition of Europe to the debtor countries.  This is inevitable with current policies.

But there’s another feature of what’s going on which leads me to highlight the Great Carry Trade.  Investors – ironically as a result of articles like Larry Elliott’s – see the big opportunities as in the developing countries.  What was a minor part of portfolios is becoming mainstream, egged on by the investment industry.

Why do I talk about a “carry trade”? Well, the effect of investment in higher-yielding currencies is – whether or not one organisation carries out all parts of the transaction – borrowing in the low-yielding currency (the dollar or pound, say) at low interest rates to lend (or invest) in a high-yielding currency (such as the rouble or renminbi).

A key point is that all the dollars or pounds invested come straight back. Think about it: to invest in China, you (or an intermediary) have to sell your dollars to a bank to buy the local currency. These dollars are then available to lend on the international money markets, depressing dollar interest rates. The carry trade is self-fuelling, reinforcing the trade imbalance.

With free-floating currencies, the capital flows will eventually force up the currency of the destination country, and investors will no longer see the opportunities they did. There’ll be some kind of correction, quite possibly an “emerging market crisis”.

But with pegged countries there are fewer ways out. Obviously there is a possibility of investor confidence becoming undermined and an asset (e.g. stock market) bubble bursting, but failing that, either inflation could occur or the currency peg could break. But both of these tend to help the foreign investor, by increasing the value of their assets. The pegging country is likely to find itself in a policy straight-jacket. Increasing interest rates to cool the economy simply encourages the carry-trade. Hinting at appreciation, or a limited appreciation, of the currency is likewise a red rag to a bull. They could try to directly control the capital flows, like Brazil did recently, or try to manage asset values directly. But such policies are difficult to implement. All very unsatisfactory.

I can only conclude that unless emerging market currency pegs are abandoned we will simply have a repeat of recent history, with a slightly different flavour.

Much depends on what happens in the deficit countries. Current policies suggest that governments will try to rein back on their borrowing. That leaves even more potential for bubbles in the property and the corporate capital (equity and bond) markets.

It now seems to me that in the UK, at least, property prices will resume their upward path. This will be driven not by low-income owner-occupiers, and maybe not even by the recent type of buy-to-let investor. Rather corporates will invest, which will increase construction rates (because such investors require large numbers of properties), which will help fuel the economy, sucking in more imports, of course. Foreign buyers will also continue to stoke the market, particularly in London. Interest rate increases to choke this off will have limited impact as they will tend to push up the pound, encouraging the very imports and capital flows that are fuelling the Great Imbalance.

In an even world, investment flows into UK equity and bond markets should, over time, exactly counterbalance flows out. But we live in an uneven world. Furthermore, when capital returns to the UK (or US) it has had the risk taken out of it. Companies, just as in the dotcom boom, will, even when raising equity is possible, still over-leverage.

Where the next gasket blows is anybody’s guess. Remember, excessive capital flows will once again be a global phenomenon. Governments will try to shore things up, but will simply have not enough thumbs to stick in all the dykes that could burst.

Jay Rayner’s review of the Eastside Inn in today’s Observer magazine includes an unforgettable comment about its owner, “chef Bjorn van der Horst, who has the name of a porn star and the palate of an angel.” My partner wondered how Rayner comes up with something like that. I suspect it’s not that difficult – though it is a very good line – if all you have to do for a living is stuff your face and write about it.

Because clearly the restaurant reviewer has not been keeping up with the London Evening Standard newspaper (“the ES”). Rayner expresses surprise that fewer London restaurants have not “gone to the wall”. He goes on: “according to Harden’s, a fine restaurant guide in so many ways, London closures have actually been slightly down over the past year, at just 64 – the lowest rate since 2000. Openings are up 9%.” But a few weeks ago the ES revealed that because so many of the sorts of people who patronise upmarket eateries have had a mortgage windfall, takings have survived the downturn.

The point is that many mortgages have reverted (from a fixed rate) to banks’ standard variable rates (SVRs) which in many cases are tied to the Bank of England’s base rate. Tracker mortgages are again tied to the base rate.

Presumably the Guardian’s Miles Brignall is either not a gastronome or is simply insufferably smug, so has not accompanied Jay Rayner on any of his restaurant trips. If he had, Jay would be well aware of how Brignall has an interest-only mortgage, for which the monthly payments have decreased from almost £900 to £150.

In what must rank as one of the most irresponsible pieces of financial journalism I’ve ever seen, the Guardian ran a short piece by Brignall in Saturday’s Money section, perhaps to provide “balance” to a report on the FSA’s proposals to discourage interest-only mortgages.

Journalists often introduce “balance” when in fact there is no widely-held alternative position. The classic example is climate change. Approximately 999 out of 1,000 scientists working in the field broadly accepts the consensus view of the warming effects of human greenhouse gas emissions. But the crackpot 1000th all too often gets a platform. Result: the public believes there is a fundamental debate when in fact there is no such thing.

The FSA pointed out that (1) if someone takes out an interest-only mortgage when they could not afford a repayment mortgage for the same amount then they are likely to have a problem paying the principal at the end of the term of the mortgage and (2) it would be a good idea for people taking on interest-only mortgages to demonstrate that they have an investment vehicle for paying off the principal, e.g. an endowment policy. Such endowments were of course very popular back in the 1980s.

What the FSA says is very sensible.

But Miles Brignall appears to have committed both the cardinal sins. He writes that:

“By going interest-only, nice houses with gardens (well, vegetable-growing area) suddenly became affordable – all for the same monthly repayment had we gone for a smaller home, with a tiny garden – but funded with a repayment mortgage.”

And Brignall’s scheme for paying back his mortgage? Arbitrage:

“The pay rate on our mortgage is 1.24% – courtesy of the Bank of England – and yet I’m getting 3.01% on my Manchester Building Society Isa. You don’t need to be Mervyn King to know that that’s a good state of affairs.”

This is absolutely nuts. It is a pure cock-up that mortgage rates are lower than the rates paid on consumer deposits. The banks simply did not expect the Bank of England’s base rate to go down to 0.5%. Stupid. What the banks should have done, and will do in future is tie all mortgages to LIBOR – the cost of money in the interbank market – so this situation will not recur.

In bailing out mortgagees and other borrowers in general, by reducing interest rates dramatically, the Bank (the Bank with a capital “B” refers to the Bank of England) has, likely unintentionally, given a massive windfall to hundreds of thousands of borrowers with these daft mortgages for which the payments can drop to virtually nothing. A lot of them are spending their fortunate gains in restaurants, so we haven’t had a shake-out to separate the decent restaurants from the salmonella-factories.

From the Bank’s pov (point of view) reducing the rate so low doesn’r make sense in the long-term. Since in future fewer commercial rates will refer to the base rate, the Bank has got its powder wet.

—

The other recommendation by the FSA is less sensible. They want to ban self-certification mortgages. These have pretty much disappeared already, but the FSA seems to be keen to lock the self-employed and those with irregular income out of the mortgage market altogether.

All this will do is move the problem. Those unable to pay a mortgage would be unable to pay private rent either, so landlords would find themselves in difficulty.

This observation set me thinking. Here’s my suggestion. Mortgages should simply be provided to those who, regardless of their employment situation, can demonstrate that they have been able to pay a comparable private rent. This wouldn’t apply to everyone – some may live with their parents or pay a very low rent in a shared house while saving a deposit, for example – but would help a lot of people get on the housing ladder. Some legislation would be required – but the private rented sector is under review anyway – to require landlords to provide receipts for all rent paid in full. This would be good news for landlords as the need to collect such receipts would give a further incentive for tenants to keep up with the rent. Certified receipts would likely prove more useful than references for tenants seeking to move to new rented accommodation, but they would also demonstrate that a potential mortgagee can afford a certain level of mortgage payments. This would translate to a given size of mortgage. Mortgage lenders would require proof of rent payment for a number of years (at least 2 or 3) – this might vary for different offerings (e.g. depending on the deposit the buyer is able to put down). Some slack would be required. There are a few extra costs (e.g. maintenance and insurance) which property owners have to pay but tenants don’t. The big problem, though, is that interest rates can increase (and mortgages may be at “teaser” rates, liable to revert in the future to a higher rate, such as the lender’s SVR), causing difficulties for mortgage holders, so the government (or perhaps an independent regulator) would have to advise the rate for which affordable payments should be calculated, which may be somewhat above the market rate at any particular time.

An example is in order. Let’s say someone has been paying £1200pcm in rent for a few years. A lender might then assume they could pay a mortgage of £1050 a month to allow for other homeowner expenses. They may also allow for future interest rate rises, so accept the application only for mortgages requiring monthly repayments of £900. Got it?

What we’re trying to do is establish what outgoings a mortgagee can afford, so it is much more logical to establish what outgoings they have been able to afford in the past than to simply examine their income.

—

Postscript: Miles Brignall’s mortgage

Miles lets on that he’s paying 1.24% interest at the moment and that this works out at £150 pcm, or 12*150 = £1800 pa. Therefore on a house he tells us is worth £390K (or is that what he paid for it?) the mortgage is (100/1.24)*£1800 = ~£145,000. From a lender’s pov, £245K equity (reasonably plausible if, say, they bought their previous flat in the mid 1990s – they might have taken out a mortgage back then of well under £100K, with even less than that outstanding 3 years ago) is reasonable security, so they’re not the ones likely to get their fingers burnt.

Miles was paying “almost” £900 pcm before rates started tumbling or 6 times as much as at present. He may have paid off some of the mortgage, but at £250 a month for at most 3 years, not very much (no more than £9,000). This means his rate was getting on for 6*1.24 or over 7% (check: 900*12/154,000 = ~7%. Quite expensive, it seems to me.

How the rate has dropped by ~5.75% is difficult to explain, as base rates haven’t fallen that much (they were 4.75% in late 2006, rising to 5.75% in late 2007). Maybe the “almost £900″ was a reasonable bit less and the £150 is rounded up (or perhaps includes a fixed amount – e.g. insurance of some kind) or maybe he’s paid off a bit more than I’ve reckoned.

Anyway, most worryingly, Miles says he is only putting £250 a month into a savings account, so he’s getting used to having £400 extra to spend each month (£400 comes from the £900 mortgage payments less £150 he’s paying now, less the £250). I hope Mrs B doesn’t get too used to all those meals out!

Be very clear: the reason Brignall was able to obtain a mortgage on a £390K property was not because of the affordability of the monthly payments – it was because he had so much equity the lender didn’t consider him much of a risk. It’s the same as the logic behind sub-prime lending when banks thought they couldn’t make a loss because the value of the property would rise. Miles can presumably afford even £900 a month, but, in fact, he’s described exactly the sort of lending which concerns the FSA because it is in the interest (no pun intended!) of the lenders and not necessarily of the borrowers.

Someone with an interest-only mortgage like Brignall’s who couldn’t afford £900 each month could easily find their debts gradually increasing over time, as they were forced to put other spending on credit cards or take out personal loans.

So banks are to be forced not only to hold more capital but also to make “living wills” in order to prevent another Lehman’s. Everyone seems to think this is a good idea. The arguments centre around the practicality of the measure.

But was Lehman’s collapse such a bad thing?

Let’s remember that the interbank money markets seized up in August 2007. Lehman’s collapsed in September 2008. It was only then that governments were galvanised into taking decisive action to recapitalise the banks.

What are the counterfactual scenarios?

Well, let’s not spend too long discussing what would have happened had there been no credit crisis at all. Remember that inflationary pressures were building. Oil might now be at $200 and we could be looking at another decade of 1970s style stagflation. Lucky we had all those sub-prime mortgages!

Let’s consider a little more, though, what would have happened had Lehman not collapsed. Maybe the investment banks would still be limping along after a few more ad hoc injections of Middle Eastern capital and a few asset sales. But the interbank money markets would still be dead. And mortgage defaults would have continued and would have continued to have knock-on effects. Likely we’d still have had a recession and banks around the world would be facing secondary losses.

The dominant paradigm suggests some banks should be allowed to fail. Otherwise we run risks of “moral hazard”.

But if lots of smaller banks do fail, as in the 1930s, how do we stop the cascade of bankruptcies? Every failure puts other institutions at risk. Where do you draw the line?

To look at it another way, consider the collective pool of bank shareholders’ capital. Ultimately this risk capital supports lending. Whenever banks collectively start to lose money this pool shrinks. Regardless of the structure of the banking industry. Inevitably positive feedbacks develop as banks reduce lending, in what has been termed the “deleveraging” process, causing further personal bankruptcies or loan defaults and business failures and the need to rein in lending still more…

What happened after Lehman’s was that a number of government steps and some private recapitalisations arrested the deleveraging process after a few months.

The question is how else would this have occurred had Lehman’s not failed? I strongly suspect that we would have had a longer, more drawn-out recession. This would have allowed more time for adverse economic and social consequences, such as protectionist steps and the rise of xenophobic extremist political parties.

I put it to you that we need to retain banks that are too big to fail, so that when they do fail everyone is scared shitless and overcomes the ideological obstacles to radical steps to solve the problem!

———

I add some codas:

(1) Market lore is that financial crises only bottom out when there is the failure of a systemically important institution. There’s a reason for this. It’s only then that governments take actions they would not previously have contemplated.

(2) We’d all be in a much better place if there were better ways of getting private capital into ailing financial institutions.

(3) We’d all be in a much better place if we abandoned the ridiculous idea that “moral hazard” is best applied to corporate entities. We don’t want any banks (or other public companies for that matter) to fail – because this simply propagates a bankruptcy cascade. What we want is for them to raise additional capital and for the shareholders to fire those responsible for destroying value.

(4) Having observed recent events closely, I’m highly sceptical that mandating banks to hold more capital “in the good times” is going to work. The problem is that no government will relax the capital limits as we head into a crisis. The 2008-9 recession has broken all records. When the next downturn starts, no-one will know how deep it will be. Governments will keep their powder dry and banks will reduce lending to restore their balance sheets. Again.

The debate as to what to do to try to prevent a repeat of what I like to term the Great Crunch absolutely amazes me. There is virtually no analysis of what actually happened; instead the debate is dominated, it seems, by pre-existing prejudices. The whole financial crisis was caused by a cascade of bankruptcies, starting with so-called sub-prime lenders in the US and ending with Lehman’s failure, after which the authorities finally took decisive action.

Let’s start first with the least of the culprits. I worked myself into a bit of a lather late yesterday after reading a column by Vince Cable in the Times – see my comment there at 10:23pm on 20/10/09.

Why oh why do we persist in trying to devise policies to save people from themselves? Drugs? Ban them! Totally ineffective, in fact counterproductive, in fact worse than counterproductive in that the policy creates worse problems than those it doesn’t solve.

What we should be doing, in general, is equipping people to save themselves from themselves.

Tightening regulation of lending, it seems to me, is part of a paternalistic infantilising trend in our doomed Western societies that has been repeatedly shown to fail. It’s the wrong design principle, as was pointed out – to make a leftfield connection – in a thoughtful letter from Merrelyn Emery in last week’s New Scientist. Merrelyn notes “[t]he unstable nature of DP1 [hierarchical] systems” in comparison to “DP2″ type systems “in which adaptation depends on regulatory systems built into the operational parts of the system itself”. Quite so.

Back to Vince in the Times. Vince, it seems, very much approves of the regulatory proposals announced yesterday by the FSA’s Hector Sants. If there is a shred of understanding in my grasp of recent history, the FSA, of course, has shown itself to be entirely incompetent in enforcing the regulations it already imposes, so one has to imagine that tighter checks on mortgage borrowers will also be ineffectual.

The whole proposition makes absolutely no sense. It rests on no sound analysis. Here’s a more subtle way in which it will fail. Mortgage defaults in the UK are an inevitable result of this or any other recession. They arise because mortgages are a 25 year commitment, a long-term loan, whereas income is paid on a short-term basis. Mortgagees are no different to banks which lend long-term and borrow short-term. Proving your income at the time you take out a mortgage has minimal bearing on your ability to pay the mortgage over the long-term. As the economy now comes out of recession the housing market will pick up. Happy days will be here again, and the buyers will be once more out in force. Inevitably a proportion of them will lose their jobs in the next recession.

In actual fact, banks diversify their risk when they offer mortgages to those with sources of income other than regular employment. We know that employees will be made redundant in the next recession. Many some of those with other forms of income may well continue to be able to pay their debts.

If we’re to put the onus on banks the problem never ends: next we’ll be asking banks to evaluate the security of mortgagees’ employment. Then we’ll be requiring them to ensure mortgagees have access to funds to pay the mortgage if they lose their job and so on…

Hey why not take the same approach in other areas of life? Why not, for example, mandate bar staff to ensure customers can actually afford to buy the booze they want? Oh, sorry, our paternalistic policy for drink is to put the price up. That’s odd, because in earlier eras the problem with heavy drinkers was not so much that they destroyed their health or caused a nuisance in the town centre. Rather it was that they destroyed the family finances.

No, no no! What’s needed is tough love. People need to take responsibility for their own finances. What sort of policies would this imply?

Well, first, it might be an idea to tell people that the economy experiences ups and downs. Companies fail. Even in the public sector people can be laid off. So those planning to take on a mortgage need to judge what would happen if their personal circumstances changed. Do they have sufficient savings to tide themselves over? Could a couple pay a mortgage on one salary?

Second, we need to look at the balance between greed and fear in the housing market. When the market is rising people pile in. And I don’t blame them. This time round we’ve sent the message that there’s not much to be afraid of. The dominant narrative consumed and constructed by those who drove house prices to unsustainable levels is characterised by indignation against the banks rather than by remorse, by scapegoating rather than by learning. And there’s more: many have been saved by low Standard Variable Rates (SVRs). There’ve been few stories of borrowers being pursued for their debts. Compared to the 1990s we now have Individual Voluntary Agreements (IVAs) and one year rather than 3 year bankruptcy arrangements. As I pointed out a couple of weeks ago, we’re even allowing people to take banks to court over perfectly clear mortgage terms.

In actual fact, as the ultimate inditement of complete regulatory incompetence, I can’t help observing that right now I’m sure I’m not alone in having just taken on board the lesson that I should have run with the herd and taken on a mortgage when I had the chance! Regardless of house prices.

My recommendations are completely opposed to current mainstream thinking. But perhaps that’s because I’m looking at what actually happened. The whole financial crisis was caused by a cascade of bankruptcies, starting with so-called sub-prime lenders in the US. Why Northern Rock was left floundering when it was, and ultimately nationalised is still completely beyond me, but A&L, B&B and HBoS failed to a greater or lesser extent because of fears about defaults in the UK housing market. NR would presumably have been in trouble later on had the odious Mervyn King not decided to “make an example” of its reliance on money-market funding. The cascade continued as even the soundest banks were stressed by a secondary source of losses: the recession arising from the original financial crisis.

So to snuff out the next one, why don’t we start at the beginning of the cascade by increasing the value of these dodgy mortgage debts?

Here’s my recommendation: treat debts from bankruptcy in a similar way to the UK’s student loans. That is, attempt to collect them directly through a levy on income (above a subsistence threshold) until they are repaid or for life and beyond. In effect, a bankrupt would pay higher levels of tax in the future. (I should add, that the level of interest would be low on bankruptcy debts, because the might of the state is to be employed to collect them). On death, any estate would first be used to pay off bankruptcy debts. The whole concept of bankruptcy needs to be rethought. We need to consider the general interest. At the moment, every time someone goes bankrupt, others must pay, increasing the risk that they too will get into financial difficulty. Why on Earth do we retain the archaic notion that bankruptcy can be “discharged”?

The effect on the bankruptcy cascade would be to increase the value of debts. Those sub-prime mortgage-backed securities (MBSs) would have been worth more than they were when the housing bubble burst.

That’s the stick. But we don’t want to be using it all the time. We also need policies so that the risk of bankruptcy is minimised:
- we need stable house prices;
- we need to hold house prices at the low end at an affordable level for those on the lowest incomes: in short, we need to raise the minimum wage and keep it in line with house prices.

My previous post, 50 Days to Save the World! made a simple point. If we’re planning an economic solution to the climate change problem, it’s critical that, first, we fully understand the phenomenon we’re trying to modify – the global economy, in this case.

We also need to have at least an outline understanding of the shape of the global economy of the future. My thinking has been stimulated by today’s column in the Guardian by Larry Elliott, Eastern promise holds little hope for west. But Larry doesn’t consider what will happen to China’s currency peg to the dollar. We need to listen to Bernanke, among others.

What is a currency? I expect if we surf a bit we’d find a definition that lists the characteristics of a currency. A currency, I’m sure we’d find, must be fungible (exchangeable) and act as a store of value. But these attributes are only a matter of degree. All currencies are only exchangeable under specific circumstances, some more specific than others. And some store value better than others. In fact, these attributes are shared by many physical and promissory items that are not generally regarded as currencies: gold, oil, works of art, debts (certificated or not), company shares and so on all share many of the properties of currencies.

Now, my point is that we all agree that the value of gold, oil, works of art, debts and company shares all depend on supply and demand. Currencies, such as the dollar and the yuan are no different. To attempt to peg their value is akin to defying a law of nature. Just as the tide reached Canute, so currencies will resist an attempt to confine them. Eventually the dragon will breathe flame.

China has amassed a surplus in excess of $2trn and they’re not the only culprit. The future depends to a large extent on what happens to that surplus.

Let’s first consider the problem in terms of supply and demand for dollars. China’s $2trn will lose value to the extent that the supply of dollars increases and/or there is a decline in supply of what those dollars could buy.

On the supply side, QE, for example, will tend to inflate the dollar. But so, too, will releveraging as the global economy starts to grow and any increase in trade imbalances and attempted hoarding of dollars by surplus countries.

On the demand side, though, the dollars will become worth less or more, the less or more there is to buy with them. If, for example, oil becomes priced in euros, then the store of dollars will be worth less.

Let’s make some observations:

1. The value of China’s supply of dollars depends on the dollar-yuan exchange rate only to the extent that holders of dollars wish to purchase Chinese goods (requiring a foreign exchange transaction). Externally to the Chinese economy, the dollars will still be worth $2trn, should China revalue the yuan.

2. Foreign currency reserves are being held in dollars because there are things that can be bought with dollars. Holding reserves in gold or Swiss francs, say, would introduce a currency risk. More than that, in fact, the supply of gold or Swiss francs would exceed what can be bought with them. And, to repeat a critical point, if oil should become denominated in currencies other than the dollar, then China’s dollar reserves would immediately become worth less.

3. China relies on US demand for dollars, not just for Chinese goods. If the US reduces demand for dollars by fiscal tightening (i.e. by reducing the supply of government bonds) and by controls on lending (reducing money-market rates), then China’s dollars will be worth less.

4. If China’s dollars become worth less then the value of something – probably many things – they could buy will inflate.

Now let’s try to identify some scenarios depending on US and Chinese behaviour and then consider what other players might do.

0. Asset bubbles in US: China keeps peg, US borrows

I’ve added this case later for completeness. We might, I suppose, simply repeat the Credit Crunch. It’s possible, but unlikely, that we will simply go round the same loop again. But US consumers are no longer credit-worthy and the US is obliged to try to improve its fiscal position.

1. Asset bubble: China keeps peg, US is prudent

In the most likely outcome, China tries to be cautious, maintains its export-led growth and amasses ever larger dollar reserves, whilst the US also repairs its public and private finances. It will be impossible, though, for the US to repair its trade deficit, at least with China (and other dollar peg currencies). The surplus dollars create asset and commodity price bubbles before the inevitable crash.

Even worse, there is another aspect to the problem: dollars will be exchanged for other currencies where growth prospects provide better returns. Increasingly investors will bet (like Soros on the pound) on a gain when the dollar peg finally snaps.

There must, surely, come a point when China cannot further relax currency exchange controls without immediately being forced to reflate. Surely, as soon as China starts to allow trade in yuan, no-one will want to trade at the official dollar rate. People will assume that in the future they’ll be able to buy more with yuan (i.e. demand for yuan will increase) and seek to accumulate them. The yuan will inevitably rise against the dollar much as the dollar rose against the pound post-WWII. Eventually China’s trade position will reverse. Plus ca change…

2. Inflation saves us: China keeps peg but experiences inflation

I spent an hour or two last week reading about the Bretton Woods system. My scepticism as to the worth of currency pegs was reinforced. All currency pegs do (unless they prove to be a step towards successful currency unification, of course) is slow down currency movements and force them to happen with unnecessary drama and disruption, rather than by (at least sometimes) smooth market movements.

The problem is that the currency of the trade surplus country has to inflate to restore the balance. But there is no mechanism for this to happen in an orderly fashion. Rather, the trade surplus country benefits from improving economies of scale – and it’s no accident that manufacturing leads to increasing trade surpluses, for it is in manufacturing that productivity improvements are easiest to achieve – and the only way inflation can occur is through asset-price bubbles. The Great Depression is an example of what can happen.

The risk for China, of course, is that it finds itself in the eye of the storm of a second Great Depression (or at best a Lost Decade, like Japan) when asset bubbles burst. China would no doubt wish to avoid this by evening out across the economy any inflation that took place, but this is difficult. Allowing workers’ wages to rise would actually lead to productivity increases and an even greater surplus! If commodity prices are the focus then, again, industry will use these more wisely…

3. China keeps peg, but has to spend dollars on commodities

If the price of oil (and commodities such as iron, uranium and so on) goes stratospheric and China cannot wean itself off, then more of the dollar surplus will transfer to the resource exporting countries.

This scenario could lead to something resembling stability, at least for a time. The global economy would become characterised by a kind of triangular trade. China exports to US, which exports technology and knowledge products to resource countries, which export commodities to China.

The problem, of course, is that China will tend to find substitute products for scarce commodities and, because of the currency peg, restore its surplus.

Ultimately, too, the resource exporting countries will rely on US demand for dollars.

There is great danger, too, that this scenario would lead to 1970s style global inflation.

4. China relaxes peg

The only rational course for China is to relax its currency peg to restore a rough trade balance with the US. Why risk asset bubbles (1) or try to manage internal inflation (2) or global, commodity-led inflation (3)?

What about the UK?

Well, our policy aims should be:

1. Reduce our trade deficit so that we are less prone to asset bubbles arising from lending of foreign sterling reserves to consumers in the UK.

2. Reduce our fiscal deficit to ensure we can withstand future economic crises and to reduce demand for sterling. Forcing banks to purchase government debt reinforces this policy.

3. Further reduce demand for sterling by controls on lending.

The result will be that sterling used to purchase imports to the UK (or invested overseas) must be spent on exports. Other places it can go will be minimal.

Sterling, which, fortunately, is a truly floating currency will decline until its value ensures approximate trade balance.

One thing the global economy certainly does not need right now, though, is a transfer of a further $100bn a year from trade deficit to trade surplus countries.

A while ago I started what was intended to be a series of posts detailing the causes of what I’m terming “The Great Crunch”.  I was planning to discuss the second cause today – but have decided forests merit my attention just now.  You’ve got to get your priorities right.

Nevertheless, as a bit of a trailer I feel I just have to draw attention to this Sky News story I just spotted on the handy syndicated financial news service provided by Yahoo!.  Yes, those nasty “Banks Face ‘Unfair’ Mortgage Legal Action” as Sky put it (and if their ambiguity was deliberate then I applaud it).

Well, we now all believe banks are intrinsically evil, of course, but let’s read a little further.  It turns out the noble David vs Goliath litigants took out somethings catchily called SAMS or “Shared Appreciation Mortgages” back in the ’90s.  And now the silly Sids are squealing because this time they’re not happy with how the deal worked out.  To be honest, I can’t even see why they’re upset, since they have apparently made money:

“The schemes, only available in 1997 and 1998 before being withdrawn from the market, allowed borrowers to take out loans secured against their homes, at a zero or reduced fixed rate of interest.

However, on repayment of the loans, they had to pay back an additional charge of up to 75% of the increase in the value of the property during the lifetime of the loan.

Their repayments ended up rocketing because of the sharp rise in house prices in the decade to 2007.”

The mortgagees, it seems, have been given free money (that’s what I term a zero interest loan), had the use of a property they presumably couldn’t otherwise afford for a decade or so, AND made a return of 25% of the increase in the value of the place.  Now they’re suing because, as Kevin would put it, “it’s so unfair” – presumably compared to the absurd windfall profits made by other homeowners or some other course of action they wished they’d taken back in the day.  “Aah, diddums”, I say.  From Sky’s story there seem to be no allegation of mis-selling.  The deal seems totally straightforward to me from a consumer point of view (and I’m not claiming special financial expertise here – I still don’t, for example, fully grasp why I would want to buy, for instance, “with profits” life and pension funds).

The point – which, as I say, I intend to develop further – is that – unless, of course, we want to experience never-ending financial crises – we have to somehow reach a state where individuals take responsibility for their own financial decisions.

It’s about weighing up individual interests against the general interest.  Once you strip away the bonuses, the Goodwinesque hubris, and the Byzantine financial complexity, banks are simply collective institutions for managing money.  Every dollar an individual takes from a bank undeservedly (or, indeed, deservedly) – whether as an unjustifiably (or, indeed, justifiably) massively inflated salary or bonus, through some court award against the bank, or, most significantly, through the writeoff of debt – must come from the other stakeholders in the bank.  Taking the banks as a whole, that includes all of us – especially as, at the end of the day, the taxpayer has to pick up the tab when the sucker goes down.