As I mentioned, my New Year reading includes Niall Ferguson’s latest opus, The Ascent of Money.  William Rees-Mogg got through it twice by Boxing Day, so I must be a slow reader.   But maybe a careful one, because like Cable, Cameron, Brown and Darling, I now believe I’m an expert on the topic!

Here’s what I’ve learnt from Ferguson’s Chapter 1 (they’re big chapters, all right?): there are many differences between the virtual money we have now and traditional currencies like gold or cowrie shells.  For example, it is a lot easier to achieve leveraging with virtual money than with gold.  Another salient characteristic of virtual money is that for every saver you must have a borrower.  Virtual money has to be used.  It can’t simply be stored like gold can.

Now, David Cameron seems to believe that saving is more virtuous than borrowing.  If we imagine for a moment that the UK economy were completely isolated, then banks would lend every pound that was deposited.  They would lend available cash to the highest bidder and compete with other banks to attract deposits at a lower rate than they could lend it.  Bubbles in the price of assets, such as houses, will therefore be more likely, the more inequality there is, a point made very well in a comment by Brian Barrington on a Willem Buiter Maverecon blog entry (an entry that incidentally was itself reported in the Telegraph – maybe I’ll comment on it later myself).

The UK economy is not isolated, of course.  What Cameron presumably wants to do is replace overseas savings (which reach the UK mainly via the money markets) with UK savings.  But the pool of overseas sterling funds looking for a home depends on our cumulated trade deficit with the rest of the world.  Whether or not we have a trade deficit with a particular country depends largely on the exchange rate.  If a country, such as China, keeps it’s currency artificially cheap, then they are bound to have a trade surplus, and at least some other countries will be in deficit to it.

All else being equal, and, in particular, unless the trade deficit is addressed, a higher rate of savings in the UK will make asset bubbles even more likely.  Perhaps saving is not so virtuous after all.

Money is for spending or investing.  Many commentators treat the term saving as equivalent to investment, and generally compound the problem by confusing speculation such as on housing with true investment.

Investment is the process of acquiring assets that provide an income stream.  Since the income stream has value, successful investment is a way of preserving or increasing one’s money.

Speculation is the process of aquiring assets in the hope that other people will value such assets more in the future than today.  Buying art is speculation, but so is buying property if you pay more than the value of the income stream from renting the property.  Sound familiar?

Saving is the process of retaining money in the hope that it will value in the future.  This was a reasonable expectation with gold.  Unless it was stolen, or – as Ferguson explains in The Ascent of Money – someone discovers a huge supply of it, you could be reasonably certain it would retain its value.  This is not the case with the currencies of the modern world.

It is in fact very difficult to preserve the value of virtual money.  Inflation is a bit of a headache, and as we saw in 2008, banks can go down as well as stay afloat.  Society already provides a very generous service to savers in allowing them to not only preserve the value of their money, but actually increase it (through earning interest), at (virtually) no risk.  Even if they deposit their money with an institution, such as an Icelandic bank, which is taking such risks with the money that it can pay a higher interest rate to savers than other banks, we (the taxpayer) still compensate them in full. And they’re not even grateful!  [You need to scroll to the Ron Kipps correspondence on the last two links].

Even if it’s remarkably unpopular, surely taxing savings interest as income is the least we – society – should expect in return for the service of protecting the value of savers’ money – in other words, insuring savers’ risks?

Sometimes I want to shake that David Cameron!

I’ve been thinking of posting about the inevitability of the current economic crisis for a little while now. I was a little worried about the title, since I don’t want to upset 1.3 billion people. I thought of substituting Germany for China, but that’s still 90 million, and they’re not so far away. Fortunately, though, Martin Wolf has written a fairly strongly worded piece in the FT on a similar topic. I know he didn’t actually use the words “Blame China!”, but if anyone’s offended, please see Mr Wolf, he’s bigger and badder than I am!

Wolf’s point is that, if we’re to escape from the mess we’re in:

“… the global economy will have to rebalance.  If the surplus countries do not expand domestic demand relative to potential output, the open world economy may even break down.  As in the 1930s, this is now a real danger.”

Rather worryingly, Germany doesn’t seem too keen to do its bit for the global economy.  China seems to be flying into the tackle with both feet, trying to increase demand at home, while at the same time holding its currency back.  True to form, they’re single-mindedly concerned about… China.  Of course, there is an automatic stabiliser in the system in that oil (and other resource) producer surpluses will automatically fall as oil (and other commodity) prices go through the floor.  I guess we’ll muddle through somehow.

Wolf is primarily concerned about how the global economy recovers.  Quite right too.  He also points out that household borrowing in deficit countries will have to decline.  I agree (contrary, it seems, to the UK political mainstream) – we (UK, US etc.) have to reduce mortgage and consumer lending, and invest instead.  Brown and Merkel seem to agree on one thing: perversely, both seem to think we can put things right by doing more of what got us into this mess in the first place.  Germany expects other countries to restore demand for its products.  Could be a long wait.

You have to conclude that many do not seem to understand the nature of money.  Back in the day (or in Second Life) it might make sense to accumulate gold ad infinitum.  OK, I’ll go even further.  On an individual level, money can, I suppose, be rationally accumulated and stored.  But, as they say in China, what if everyone does it?  Huge trade surpluses, Sovereign Wealth Funds and vast savings pools are, collectively, unsustainable.  This is because money eventually loses its value.  Sterling, or any other currency, is only any use for buying sterling-denominated assets, goods or services.  If too little of the sterling used to pay for our imports is spent on our exports, then eventually too much sterling finds itself chasing too few assets, since this sterling must go somewhere.  The result is that either the value of sterling falls (against other currencies) or sterling asset prices rise (aka yields falling) – and then likely crash as everyone tries to bale out.  Recognise anything yet?  I read somewhere that China was losing 15% pa on its dollar funds because of the low yield on US Treasuries and slowly rising renminbi.  Once the total fund value exceeds 100/15x of the annual dollar increment, then, of course, 1.3 billion Chinese are running to stand still in terms of what they can buy with their dollars (all else being equal).  If they intended to blow the dosh on oil, of course, they’d have been running backwards until recently.  As they say, you can’t take it with you.  You can’t even keep writing IOUs indefinitely and expect them all to be paid back.  Especially when they’re in a currency you don’t control.

Money is there to mediate trade.  It’s not a physical thing with intrinsic value.  It can only be stored temporarily.  It’s value is contingent.

All this is a lead-in to my main point.  These surpluses and corresponding deficits are a problem for everyone.  The surplus money has to go somewhere.  And there’s been so much of it (especially dollars) sloshing about for the last few years that it’s drowned everything.  After the dotcom crash, everyone wanted safety, of course.  As alluded to already, Treasury yields hit the floor.  Private equity could only find so many safe utilities to buy out.  So Wall Street and the City tried to meet the demand.  They didn’t create all those mortgage-backed securities and so on for nothing.  No, no, no.  Low-risk paper with a respectable yield was precisely what the customer wanted.  Shame the yield was – how shall we put it? – temporary.  If attitudes to risk had been a little different, then the financial crisis would have played out differently.

So, this is my proposition: as trade surpluses built up, a disaster of some kind was inevitable.  The hot money was the critical factor – sub-prime mortgages, SIVs and the rest were just detail.  Dollar assets were of course most vulnerable – who’d want to be responsible for the world’s reserve currency, eh?  Hmm, the ECB, apparently.  Not only are reserve currency asset prices driven up by demand, the problem is compounded by the currency having a higher exchange rate (amd therefore inevitably larger trade deficit) than would otherwise be the case.

Wolf is right.  We’ve got to find ways – other than protectionism, of course – to dramatically reduce global trade imbalances, not just to escape the present imbroglio, but to avoid the next one.

A few years of decent growth, then total economic disaster out of a clear blue sky – a financial 9/11.  Something’s got to have been seriously wrong all along.  We can’t just put it all down to a few dodgy mortgage salesmen.

Earlier today I wrote, a little sloppily, that:

“…the only way to arrest the deleveraging process is to increase the capital able to support lending.”

“Deleveraging” should be defined as a reduction in gearing, i.e. a reduction in the ratio of borrowing to risk capital.  This could be achieved by reducing borrowing or increasing risk capital, or a combination of the two.

What I really meant to say, then, was that the only ways to maintain lending levels are to:

• increase the risk capital employed; or
• reduce the riskiness of lending.

The problem we face is that capital is fleeing to safety – yields on Treasuries are breaking records – and lending is perceived to be riskier than before, not less risky.  Only a few contrarian investors are putting their toes into the water and, in the case of Northern Rock, for example, rather than support them, the UK government has seen fit to expropriate their investments.  Not a lot was done to see Woolworth’s through the shock of denial of trade credit insurance, which appears to have demanded so much working capital Woolies didn’t have to have pushed it from turnaround possibility to insolvent virtually overnight.  Government concern seems to be limited to protecting jobs until the New Year by some kind of behind the scenes deal, even though the administrators would have needed to keep the stores open anyway to conduct fire-sales of stock (destroying more capital in the process).  In the absence of new risk capital, preserving the 30,000 Woolies jobs in the longer term will likely prove impossible.

Despite the recapitalisation of the banks, it’s difficult to see how overall lending levels can be maintained until a floor is put under the destruction of risk capital (Sir James Crosby agrees – see below for more discussion of his report).  If the government takes on too much debt [or risk - and note that fully nationalising the major banks, as the loonies are talking about, would be to take on the risk of entire multi £100 billions balance-sheets], Brown will likely become the next Callaghan, cap-in-hand to the IMF. We can’t simply spend our way directly out of trouble. The focus should be on investment, not VAT reductions.

We’re therefore going to have to make some choices on lending.  Broadly, if we have any brain-cells, we will realise that we have to reduce mortgage and consumer lending, and, if possible, increase lending to business.  It seems to me we should simply let the banks do this.  Allowing them to increase real interest rates to consumers (but likely still reduce nominal interest rates) would help rebuild their balance-sheets.  Interference may well be counter-productive, since the government has the ulterior motive of needing to keep the voters happy in the short-term.

Here are three scary indicators (apart from the VAT reduction) that the UK’s establishment is in headless-chicken mode.  In the words of everyone’s favourite football chant, Darling, “you don’t know what you’re doing”:

(1) Having slept on it and having printed off the Introduction (actually a Summary) to his report, I am even more astonished than before that Sir James Crosby (a mortgage-banker, of course!) thinks we can or should actually increase net mortgage lending over the next couple of years.  If we do this, the result, sure as eggs, will be to reduce other forms of lending, i.e. to corporates.  This will lead to more redundancies and defaults on mortgages…  Crosby, bizarrely, seems to consider the mortgage market in isolation to the rest of the economy.  I repeat, house-price falls per se will not lead to defaults in the UK (because we don’t have no recourse loans).  As long as interest rates don’t spiral up, unemployment will be the main cause of defaults.  We therefore need to keep people in work, by preventing unnecessary corporate bankruptcies.  Like Woolies.  Good start, guys.

(2) Today’s Grauniad included a graphic (not included in the online version of the article) showing what countries were spending money on to try to boost their economies.  The UK blob starts with “tax cuts”.  Germany?  “Infrastructure, green technology and tax breaks on new cars” (not sure about the cars!).  France?  “Help for industry”.  Spain?  “Extra spending on roads, transport and tax relief over 2 years”.  Only the UK, it seems, is borrowing for consumer spending on imports.

(3) Then there’s Mervyn King’s confused remarks to an MPs’ Committee.  Nils Pratley, among others, expresses his puzzlement.  He runs some numbers and reaches the conclusion that: “There is a funding drought.”  I say again, do we want to sacrifice good firms to try to maintain what looks more and more to have been a house price bubble?

Interest rates are likely to be decreased even further next week.  And again, the banks’ arms will be twisted to reduce their SVRs, preventing them from rebuilding their capital.  And preventing them from supporting businesses (the failures of which will blow more holes in bank balance-sheets) and reviving the economy, leading, in the longer-term, to less new mortgage lending, more defaults due to unemployment and an even greater drop in house prices than would otherwise be the case.

The Times’ Anatole Kaletsky was on stage at a conference I attended last week.  I can report that his picture tells only one lie: in real life he does indeed bear a passing resemblance to a famous comedian, but to a somewhat older Jasper Carrott than implied by his mugshot in the Times.

So I made a particular point of having a look at Kaletsky’s column this morning.  In an article where he undermines his credibility by committing the cardinal sin of arguing “first” and then “Secondly” (at my school such a mistake would have resulted in a high velocity blackboard duster aimed right between your eyes), Kaletsky supports the government’s recent VAT giveaway, arguing that: “for every saver there has to be a borrower”.  In the 5 words the Times comment facility allows me, I tried to point out that the real issue is leverage.

Savings and borrowings can go round and round.  I might use an overdraft facility at my bank to borrow from Anatole’s savings to go to Woolies to stock up on sweets at firesale prices.  This money would then go into a bank account belonging to Deloitte’s (Woolies’ receivers) and could be used to support lending to someone else.  This process can continue indefinitely.

However – and isn’t there always a “however”? – all this lending has risk associated with it.  I might suffer amnesia after an attack on my way home from Woolies by some sweet-mugging hoodies and never pay off my bank overdraft.  Banks need a buffer – let’s call it “shareholder capital” – to cover the risk of people not paying back their loans.  This limits the amount of borrowing and lending that can be undertaken via that institution.  The total amount of lending and borrowing that can take place in the economy is obviously the sum of the lending by all banks and other risk-taking intermediaries – including the state, a point I’ll try to get to later.

The primary problem is not, as Anatole imagines:

“…that private citizens and businesses are in a panic and have suddenly decided – or been forced – to cut back their borrowings and increase their savings to an equally unprecedented degree.”

The problem is that, due largely to the US sub-prime crisis (and the complete and utter madness of no recourse loans), but also other cock-ups that have exacerbated the original problem, such as permitting banks to conceal the real extent of their leverage by the use of off-balance sheet vehicles, and the insanity of mark-to-market valuation of bank assets, a huge hole has been blown in the capital of banks worldwide, including in the UK.  This has meant they can lend less, and has initiated a process of deleveraging, which, due to various feedbacks (such as knock-on bankruptcies) resulting from less willingness to lend or a higher cost of capital to individuals and firms, tends to feed on itself.

Now, the only way to arrest the deleveraging process is to increase the capital able to support lending.  This would happen, for example, if you could persuade Anatole and a few thousand other Jasper Carrott doppelgangers to withdraw their savings and instead invest the money in rights issues by banks.  The banks would still have the actual cash, but could use it to support – or leverage – the merry-go-round lending I have described, rather than just lend it out once as was the case when it was on deposit.

We should therefore assess government policies on the basis of how effectively they counter the deleveraging process, not on the simplistic basis of how much money they put into the economy.  Let’s have a look, then, at what’s on the table:

(1) Recapitalising banks: obviously very effective (but see below).

(2) A reverse auction for “toxic assets” (e.g. the original idea of the US $700bn TARP programme): this might have been very effective as a price-discovery mechanism, since banks may be perceived by the market (despite any suspension of mark-to-market accounting rules) to have less capital than they really do have, and their lending therefore restricted.  Although it may seem more expensive than (1), this measure may be necessary on a limited scale.

(3) Reducing VAT or other taxes: such measures simply encourage spending, which may go on imports, increasing the overall debt (private + public), and leverage, of the nation.  On the plus side, tax reductions may keep some retailers and suppliers afloat, saving jobs and resultant bankruptcies and loss of bank capital.  But is this really the best way to reduce the risk of future bad debts and arrest the deleveraging process?  I seriously doubt that tax reductions are going to prevent large numbers of personal bankruptcies, since the main driver of these is unemployment.

(4) “Public works” programmes: would directly prevent personal bankruptcies, so would give more bang per buck than tax reductions.  They take longer to implement (not attractive to politicians facing elections), but in my opinion this delay should be accepted.  We may not be fighting a battle that will be “over by Christmas”.  The government could also spend money effectively by investing in housing, for example, indirectly, by lowering costs for housebuilders.  In the UK they could reduce the indirect taxes on “planning gains”, e.g. Section 106 deals, such as to produce “affordable housing” alongside housing for sale.  Surely it would be better to build just private housing than none at all?

(5) Prevention and minimisation of the direct or indirect impact of personal and corporate bankruptcies.  This requires a book in itself, but I can’t help observing that spending a few £bn on the insurance needed by suppliers to at-risk businesses might well have saved jobs at Woolies, MFI and other suppliers (and, just as important, the capital losses to the banking system from such bankruptcies) far more effectively than a VAT reduction.

Kaletsky suggests that “the Government is right to borrow on a scale almost never imagined”. Maybe, but there is a risk to savers with governments (i.e. purchasers of government bonds).  It seems to me that this risk should always be minimised, just in case things get even worse.  It would therefore have been much better, as well as fairer, for example, as I’ve argued several times for months, if the government had acted to encourage or allow private recapitalisation of the banks, not spent public money.  Whilst talking down the pound and using interest rate policy to achieve a limited devaluation (among other things) might be a good idea, the danger is a loss of confidence in the currency.  Public borrowing costs would increase, and we could end up importing inflation or living under IMF strictures.

So my verdict is not as positive as Kaletsky’s.  The government has already gambled once by putting more public money into the banks than necessary.  It’s now throwing our chips into trying to encourage a spending binge.  I suspect this will be a last gasp before coming out of denial and starting to take the longer term measures necessary to arrest the deleveraging process.  In particular, as I wrote yesterday, we have to accept that house-prices are going to fall much more, and that over the next few years we must reallocate some of the borrowing that can be supported by the economy.  To investment, rather than speculation.

The government is being too impatient and making the error of targeting lending and spending directly, rather than the underlying cause, the deleveraging process that is causing lending to be reined in.  Rather than reduce VAT, the government should accept that the next few months are going to be grim, and invest in trying to pull us out of the nosedive in a controlled manner in spring 2009.  Brown and Darling, I suspect, are flapping their wings ineffectually.  Even if they manage to stimulate a Christmas spending binge, that won’t save us.

When you’re in a room full of unexploded bombs, it’s much wiser to take the time to defuse them all carefully than to start throwing the furniture around in the hope that everything will land safely in a more ergonomic arrangement than before.

OK, I can remember exactly where I was on 9/11; when I heard about the Challenger and Columbia disasters, the Bradford City fire and the Omagh bombing; and where I saw the Heysel disaster, the Hand of God and that 1998 England-Argentina match on TV, but I’ve rarely before felt I was seeing history in the making, day after day. This year’s Red October reminds me just a little of 1987, though. I spent an inordinate amount of time driving around the M25 that year, often in the night. So I’m listening to the music that reminds me of those journeys: Sade, for me, the sound of the ’80s.

I’m hoping that Sade Adu’s dulcet tones will help me understand the concept of risk, which is giving me a lot of difficulty just now.  Apologies if it seems I’m thinking out loud in this post, but this is my first attempt to put some anarchic thoughts on the screen.

It seems to me that the whole credit crisis has been caused by a pathology that I’d like to term risk denial.

Consider:

• most people who think they’re “investing” in housing are in fact speculating, by any sensible definition of the term: they’re hoping to profit from capital gain.  In the US, the TV schedules of the early ’00s were apparently packed with programmes about “flipping”.  Here, many buy-to-let (BTL) investors were attracted by the prospect of spectacular rises in the value of residential property, rather than a hard-headed assessment of the realistic profit on rental income, after costs.  Vast numbers of people in the UK and elsewhere are happy to buy or remain in houses much larger than they need – often sacrificing other forms of consumption – because they believe property to be a “good investment”.  An Englishman’s home may be his castle, but, it seems, so is an Irishman’s, a Latvian’s and an American’s.  In short, millions put their money into housing because they saw it as a safe way of preserving or increasing their wealth.  But as we see now, it has proved exactly the opposite.
• there has also been a supply-side to the huge demand for mortgages.  Take China’s Sovereign Wealth Fund (SWF), for instance.  It’s around $2trn and apparently very conservatively invested, largely in gilts, squeezing out other investors from this ultra-safe asset class by depressing yields.  There was obviously a market for other “safe” investments (or at least ones where the buyer felt the risk was accurately quantified).  Supposedly risk-averse investors, including Chinese government funds, I understand, have therefore been keen buyers of mortgage securities.

My point is this: in the dot-com boom too much money was chasing assets known to be risky, i.e. shares in tech stocks.  The fact that most investors were in no position to pick winners hardly put them off.  They simply spread their money about, bidding up the price of the latest hot stock to absurd levels.  The idea, of course, was that the overall returns for “New Economy” investments would be (improbably) huge, and by investing in many companies, the overall risk could be reduced.  And this can indeed be mathematically proven to be the case, as long as the risks are uncorrelated.  But what do we mean by correlation?  If we say the game is “winner-takes-all”, then only one search engine, say, could succeed.  But if Google had failed for some random reason – a crippling lawsuit over intellectual property, say – then some other company would have dominated the market.  If I’d invested in several search engine companies, then these investments would have been negatively correlated.  The more companies fail, the better the prospects for the survivors. In fact, the dot-com crash was not a result of correlation of risks – several companies ended up making billions for their shareholders – but of too much money chasing a type of asset, that is, “risky” investments.

Now, in the ’00s, it seems to me that we have had far too much money chasing “safe” investments – either low-risk, or for which it was thought the risk was understood.  All those CDOs, CMOs, CDSs and whatnots were not popular products because they were so clever.  They were successful because there was demand for them.

Ultimately, though, the whole edifice rested on the ability of mortgage-holders to service their debts, and as we have seen in the US, not only has a whole class of mortgage-holders (the beneficiaries of so-called sub-prime loans) proven to be unable to pay their interest, the law (in some states) does not even compel them to do so!

If it hadn’t been mortgages that pricked the bubble, though, then it would surely have been some other form of debt.

It seems that, when all’s done and dusted, the credit crunch has been caused simply by too much money chasing “safe” returns.

This “risk” thing, I’m beginning to think, is something you just can’t get away from.

Too many people have been in risk denial.

Can we escape from this trap?  I’ll have to think a bit more about that…