Friday 10 October 2008
Who Pays ?.
Given that its now impossible to escape the consequences of the escalating global financial crisis a simple question. Governments worldwide including our own, are now engaged in throwing billionsn of whatever currency you like to name into propping up the global financial system. Two questions arise. How long can Governments continue to do this without hitting the financial buffers themselves and who pays the price ?. I suspect that it will be as usual, taxpayers and the most vunerable and that somewhere down the line we shall see tax rises and cuts to services not to mention mass unemployment. I suspect that we are being told a good deal less then the truth about what is really going on here and who will ultimately pay for it.
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Wealth and money are not the same thing. Money is a way of measuring and transferring wealth, but it is not, in itself, wealth. Creating money does not create wealth – wealth can only be created by producing something. The sum total of wealth thus created by a nation is known as its Gross Domestic Product (GDP). Money can be created by issuing cash or by bank lending, both of which increase the money supply. An increase in money supply without a corresponding increase in wealth is inflation. Markets do not create or destroy wealth, they merely re-distribute money. Markets are a “zero sum game”. For every loss there is a gain and in total no money is lost or gained through the operation of markets. The current market turmoil has not, therefore, created or destroyed wealth, it has merely re-distributed money.
So, if so many appear to be losers in the current economic situation, who are, or have been the gainers? Expressed another way, where has the money gone that has been wiped off the value of stocks on the world’s exchanges? To understand that, we have to look at how the inflation in global money supply came about in the first place.
For many years the average price of housing in the developed world had been about 2.5 times average annual income. However, since around 1991, average house prices have steadily risen to a factor of around six times annual income; but house price increases do not create wealth. The price increase has been fuelled by an increase in lending and, when property is sold, the price margin above the 2.5 factor represents an increase in money supply way above the increase in GPD, i.e. money supply inflation. The sub-prime debacle in the US has re-distributed money but it has neither destroyed nor created wealth; and it has fuelled land price increases above US GDP and added to the global money supply increase.
Throughout the developed world the past two decades have witnessed an unprecedented growth in consumer spending fuelled by bank lending. In the UK alone personal debt passed the £1 trillion pound mark some years ago, the growth in domestic money supply far outstripping UK growth in GDP. Much of this consumption was funded, or re-funded, by borrowing on mortgage, borrowers being deluded by the notion of “unlocking equity” in their property. Equity is an illusion, in economic terms there is no such thing as equity – only more debt.
In each case the increase in money supply outstripped the increase in wealth. This increase in global money supply has, over the past two decades, been re-directed though the operation of markets from ultimate purchasers to ultimate sellers. At the micro-economic level the sellers have been the gainers and the purchasers the losers in the zero sum game, and at that level the losses are real and painful. But at the macro-economic level we are all collectively both losers and gainers in the game. What we are witnessing, in the tumbling of land and share prices, is a reduction in global money supply to a point where it is once again in line with global GDP. Put simply, for the past twenty years the western world has been living beyond its means, spending more than it has been earning, and now that debt has to be repaid. The question is whether Planet Earth plc is earning enough to do that and feed itself.
Governments have no assets, only income. To resolve the current crisis will require the injection of vast sums of money on a global scale. As governments have no assets they must raise the money needed from their populations either through taxation or by the sale of government debt. Both of these mechanisms take money out of circulation and reduce the money supply, over time restoring the balance between global money supply and global GDP, and thus collectively repaying the debt we took on by overpaying ourselves for twenty years. The affects on the economies of the G7 and beyond will be profound, postponing real investment for years to come. Without the elasticity previously provided by the exchange rate mechanism the affect within the eurozone could be even more profound than in the US or UK, and there must be a real fear of a return to thirties-style protectionism and sovereign default, especially in the developing world. How China and India will react to the new order remains to be seen.
Governments have no assets, only income. To resolve the current crisis will require the injection of vast sums of money on a global scale. As governments have no assets they must raise the money needed from their populations either through taxation or by the sale of government debt. Both of these mechanisms take money out of circulation and reduce the money supply, over time restoring the balance between global money supply and global GDP, and thus collectively repaying the debt we took on by overpaying ourselves for twenty years. The affects on the economies of the G7 and beyond will be profound, postponing real investment for years to come. Without the elasticity previously provided by the exchange rate mechanism the affect within the eurozone could be even more profound than in the US or UK and there must be a real fear of a return to thirties-style protectionism and sovereign default, especially in the developing world. How China and India will react to the new order remains to be seen.
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