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When things are going well not many people concern themselves with financial matters and the economy. It is only when there are problems that we come to realize how complex and parlous the economy has become in a relatively short period of time. We can now lend and borrow from people we have never met and what's more the agents we think we know and trust don't know us or the parties they are dealing with. Basically, it is all down to trust that the agreement we make will be honoured - but occasionally we find this trust is misplaced as in the case of Equitable Life.

Basically, I look at this from a UK perspective which can be quite educational for other countries since it is an object lesson in how a country can have unprecedented growth for ten years, and be held up as an example of how to run an economy to the rest of the world. But as they say all good things have to come to an end and unfortunately the end is coming fairly rapidly. So we have an economy far more extreme than the USA, dominated by Financial Service, Manufacturing pretty well gone or sold off, Private Equity trampling everywhere, a currency in decline, house prices probably about 30 to 50% overvalued, inflation massaged to artificially low levels (does the price of a DVD really matter when every other basic human need is shooting up in price?) and a central bank that is largely irrelevant (who cares about base rate when mortgages and savings rates are much higher). Welcome to my rant!!!

Technical Considerations

My other reason for this series is to show off some of the Silverlight technology which is starting to revolutionize the way web applications are built and how they can enhance our understanding. I chose the Silverlight environment for several reasons; firstly because I can employ managed code in the NET framework, I can use C# as the programming language of choice and most importantly it brings this technology within the reach of individuals without too much outlay. Actually, if you have a look at some of my other web pages you will see this means zero outlay, which is always attractive to anyone with a slight financial bent. Recently I have tried out the Google Chart API, which admittedly is easy to use, but I found Silverlight offers a much richer experience with more flexibility.

Example Using Silverlight 2

This is actually a chart of Alliance and Leicester Bank, Bradford and Bingley Bank and Halifax Bank of Scotland share price since 2000. You can clearly see the impact of rate cuts on the share prices during 2005 when interest rates were wrongly cut when BOE Chief King and deputies opposed a rate cut in June 2005 and were out-voted on a rate hike in August 2005. Bank shares rose, credit lending accellerated out of control leading to ever higher house prices. You can also clearly see the aftermath of the Northern Rock fiasco and the subsequent impact of the credit crunch post July 2007. Classic example demonstrating what can happen when a Central Bank loses control. For the technically minded this chart started life as a MySQL database, which was then imported into OpenOffice Calc and the line charts were produced. I then used Excel Viewer to view the chart and copied the chart to the clipboard. It was then straightforward to paste it into Paste2xaml to obtain xaml code. Then using my SharpDevelop Silverlight 2 template I compiled the xap file (only 9 Kb) and then added it to the web page. The advantage now is that it is very easy to use Silverlight to animate the chart e.g. to highlight values when the mouse hovers over the chart.

Footnote - It comes as no surprise to see all three of these banks having lost their independendence (as at 1/10/2008) following in the footsteps of Northern Rock which just had a more extreme version of the same business model. The mortgage banks were always going to experience difficulties in a downturn after they expanded using money borrowed from the money markets short term and lent long term on mortgages. Bradford and Bingley with its heavy exposure to Buy to Let has seen its share price collapse and the savings business taken over by Santander with its debts being nationalised. Alliance and Leicester has now been taken over by Spanish Bank Santander with obvious implications for consolidation of its Abbey branches and inevitable job losses. HBOS is being forced into a painful merger with Lloyds TSB as the value of its mortgage book assets crumble. The resultant merged entity will need a number of years before it can repay the government debts and escape the claws of partial nationalisation. As negative equity increases expect to see these effects broaden out into the mutuals - already we are seeing mergers going on quietly in the background.

DON'T READ ANY OF THE FOLLOWING PARAS

If time is short then just take a look at The State of The American Economy in One Chart. If you are interested in the UK just subsitite Bank of England for Fed - you will then see why house price rises have been inevitable up until now and why the Government has secretly engaged in an 'open door' immigration policy. The conclusion he reaches is the same as mine - big inflation is on its way within the next 2 years. If you want to see how the banks really operate don't listen to any of the politicians (not even Vince Cable) just watch Anatomy of Casino Banking. This lady knows what she is talking about.

Phase 1 - The Credit Crunch

During the 20th Century we used to have Credit Squeezes' which were signalled by the Central Bank raising interest rates by 2% at a time. In those days Central banks had real power and could rein in loose credit at a stroke. OK we had cycles of ups and downs commonly referred to as 'boom' and 'bust', but everything carried on. Now we have a 'Credit Crunch', Central Banks have little power, move rates by 'namby pamby' quarter per cent and the whole economy freezes up. Now we have reached the state where bankers don't trust other bankers and so we have the credit crunch which came to peoples attention round about July 2007 and was at first sight dismissed as a local problem to the USA. Why is their so much turmoil? First of all most of the losses are secretive and not even on balance sheets yet. Why won't banks lend to each other - because they have to keep as much cash as possible to bail out their SIV's and SIV Lites. Some SIV's are having to liquidate - with force sale of assets at very low prices. I am no expert in this area, just a beginner trying to understand what is going on, what sort of mess has been created and what courses of action are needed to come out of it at the other end. Clearly there would seem to be a need to regulate a system that creates long term debt but relies on short term investors to service that debt. Regulation does fly in the face of globalisation, but then the evangelists of globalisation have to grow up and make sure that there are level playing fields. It will be interesting to see if the ECB bring back exchange controls in order to curb inflation and protect growth. During a period of unprecedented economic growth the risk element has been levelled across all types of financial products so that packages of sub prime loans have not carried a much greater premium than prime loans. This drive to equalize and lower the borrowers rate is now in dramatic reversal as growth slows. So at first sight it would seem that most of these problems have been caused by failure to manage risk properly with both cases of reckless borrowing and reckless lending. We have a system which has a light touch on regulation allowing people and banks to largely regulate themselves. This is great all the time that there is enough common sense to avoid risk but fails spectacularly when there are safety nets available such as state handouts for mortgage repayments and Central Banks bailing out the large banks. The so called 'moral hazard', never has worked and never will when the problem is very large such as the case when a major bank goes under - the Central bank has no option but to jump to the rescue and all the major banks know this, which is why in the past there used to be a very strong regulatory system in the UK. Moral hazard seems to mean in practise that the banks have no morals and the tax payers bear all the hazard.

Phase 2 - Government Debt

As this is written (July 2009) the UK is well into the next phase of the economic crisis, having shifted some of the problems of the Credit Crunch into increasing Government Debt. Now the stakes are higher with whole economies and nations at risk as the debt bubble is moved from the banks to the Government (i.e. Taxpayer). Of course the sums are so vast that they can never be repaid at the current debt value. This means that Governments have to revert to the old tricks that have got them out of messes in the past. The first method is to disguise the extent of the debt problem, then there is debasing the currency (currency devaluation and inflation works well here). Being outside the euro area it is possible to use the euphimistic Quantative Easing to create more money out of thin air. When assessing a countries ability to repay debt a measure that is often regarded as key is ratio of debt to GDP. So if you can inflate GDP then the debt ratio does not look so bad. However, at the moment three of the factors are failing to take off - currently, if official figures are to be believed, we have retail price deflation (NB the governments preferred measure of inflation, CPI is still showing modest inflation). Devaluation against the Euro and the dollar has come to a grinding halt as these economic areas suffer much the same problems as in the UK. So Government debt just continues to grow in real terms and meanwhile GDP is still shrinking - we have to borrow more money just to keep the economy ticking over. The end game comes when a nation either is refused any more credit and or there is a default on the repayment of debt. All of this activity is going on in the UK against a background of politics where the incumbent Labour Party has had the misfortune (many would say they laid the seeds due to cavalier approach to regulation and reckless Public spending) to preside over this Boom and Bust over the last ten years and are desperately trying to win an election in May 2010. I just thought it interesting to show a chart of National Debt as a % of GDP - certainly we are well over the 40% level set by the Labour Party and whilst current levels are high, the percentage figure has been much higher in the past. Now there are concerns that the National Debt is getting out of control again risking at best much higher debt repayments on the interest and at worst a currency collapse (visit to the IMF). I produced the chart using the Visifire Silverlight Charting Library. There is still a bit of tidying up to do as I learn how to use this a bit better, for example it would be nice to show the growth of National Debt over the years (in real terms) and also to explain GDP a bit better. By looking at all of these factors it is then possible to see why the Phase 3 scenario below cannot be avoided.

GDP

This equation is often used to define GDP:-
GDP = consumption + gross investment + government spending + (exports - imports)

In a prolonged recession it is difficult to increase consumption, because the natural instinct of the consumer is to save to tide them through the bad times. Also, if consumption is increased as a result of more imports then the two affects cancel each other. So this is where talk of the 'deflationery spiral' comes in - House prices fall, the 'feel good' factor disappears, so consumption goes down and GDP goes down.
Gross Investment - This can be any investment by companies in areas such as transport, energy - in fact anything that is going to reduce expenditure in the future
Government spending is currently only being sustained by Government borrowing. Once the borrowing limit is reached then the next step will have to be a decrease in Government spending.
Exports are the traditional way out of a depression. The devaluation of the currency will help this process, provided there has been investment in viable technlogy.
Imports will have to be held in check until the GDP recovers.
The very strong correlation between house prices and consumption means that the only short term method of increasing consumption is to stabilise house prices. This is one of the main reasons why so much of government spending is being directed at the banks in order to produce another little credit bubble. The finance sector is needed to sustain the housing market.
Why is GDP so important? - GDP is the measure used to assess a nations wealth. GDP is used to set percentages on government spending - so if GDP falls then for example although the percentage going to the NHS stays the same, the actual amount declines. The amount a country is able to spend on defense is also dictated by GDP.
So the inability of the Government to allow the finance sector to stand on its own feet together with its inability to regulate the finance sector means that the UK is saddled with a disfunctional economy that is not allowed to correct itself. Enter QE (Quantitative Easing) the pallative that offers magic recovery by printing money. Unfortunately, all printing money or debasing the coinage, ultimately results in Inflation. it may be one or two years down the line long after the current administration has been booted out. But inflation will occur probably sooner than most commentators expect.

The 1970's

When looking at the GDP and National Debt figures after about 1971, the GDP and national Debt curves take off - why? The only conclusion is that there was massive inflation and devaluation of the currency so that based on Retail Price Index £1 in 1971 was worth £10.59 in 2008. If the average earnings figure is used then the worth of a 1971 £1 jumps to £18.82 which pretty well explains the curve. So using the increase in RPI a GDP figure of £1419.55 bn becomes £134.0 bn in 1971 terms - the GDP figure for 1971 was actually £57 bn. However if average earnings figures are used then the comparable figure drops to £75 bn - so in real terms the increase in GDP over the last 37 years only amounts to a 76% increase or about 2% growth per year.

Phase 3 - Payback Time

Payback time is predicted to come for the UK after the May 2010 election and will be painful for all concerned, whichever party is elected. Up to this point in time a collapse in all the banks and a corresponding collapse in house prices has been avoided at the expense of increased borrowing. The borrowed money seems to have been spent (not invested) in maintaining the banks and their bonus culture and maintaining public expenditure on the 'sacred cows' of health, education and miscellaneous social experiments. Some of the money has gone into the current mini bubbles of property and the stock market. Unfortunately whilst this expenditure has increased employment in Public Service, the Private Sector has been thrown to the wall. Some of the borrowings have also been used to keep inflation and base rates at an all time artificial low - the decrease in VAT has kept inflation much lower than it would have been otherwise. Once the housing costs and oil price lowering has worked its way through and VAT is raised back to normal, then inflation will start to rise again. However, the inflationery affects may be rather modest if the called for reduction in standard of living sends the country back into recession. This is the so called double dip which happened in the 1930's and looks like being a distinct possibility for the USA and UK.

Increased Taxes

The ability of those still in work to pay increased taxes may be difficult to achieve without exasperating an already precarious situation regarding overall tax receipts. It looks certain that the VAT reduction will have to be rolled back as this will hit everyone - not just those still working.

Massive Public Expenditure Cuts

The large subsidies currently being paid to Public Sector employees will have to be reversed in order to achieve some balance in the economy. Maintaining house prices by bailing out the banks and other mortgage lenders is not a great way to invest borrowings. The only way out of the mess will have to be some stimulus to exports (which will have to include services) - this should then lead to a revival of the economy. There will have to be painful decisions on defense spending - clearly recent events have shown that there is political wish to contine with wars - but not to pay for equipment and manpower to fight these wars.

Trash the Currency

This has always been the traditional method adopted by the UK Government and has been going on in earnest ever since the panic reduction in interest rates to 0.5% and the adoption of Quantitative Easing (Printing Money). Indeed the Treasury was much taken aback by the stubborn refusal of the pound to fall during the Summer - hence at every opportunity Mervyn King talks down the economy and as at late September 2009 it looks like the pound will fall below euro parity. Trashing the pound means that imports become much more expensive, oil (priced in dollars) pushes up every price and incidentally reduces the impact of foreign debt. Printing money is also used to pay off foreign debt by a manoeuvre of the Bank of England involving buying its own debt in the form of gilts. Just suppose a private individual borrowed some gold sovereigns and then declared unilaterally they were going to pay back the debt using soveregns containing a lower gold quantity. Would you be happy lending to that person again? Once other EU countries such as Germany and France come out of recession there will be desperate measures needed to protect the pound and interest rates must soar relative to the ECB. One thing is clear - deflation will never be a threat to the UK economy as long as the pound does not join the single currency. Deflation is just the excuse used to justify low interest rates and QE.

Phase 4 - Rebalancing the Economy

It will take many years but sooner rather than later there will have to be an acknowledgement that the Financial Services industry will have to be restructured. Just as the bad old practises identified with the car industry during the 1970's and '80s had to be stamped out, so too the financial industry will need total overhaul. At the moment this is all talk - I heard Obama's talk about what he was going to do to Wall Street. The stock market never flinched and although it sounded very convincing at the time it was fairly obvious that it was only for public consumption - talk is always much cheaper than action. Nothing will be done until it is forced and currently it looks very much as if the Banks will take the money from the tax payer without any reform or even an admission that they got it wrong. At the moment the USA and UK are like giant casino operators and are able to take a cut of all the turnover - but this will not continue as other developing countries require a piece of the action. The whole trappings of hedge funds, off shore tax havens will have to be reviewed and regulated. Once this fundamental fact is understood investment will need to be rechannelled from Finance to other growing parts of the economy.

What is Covered

In this series I hope to cover some topical issues, but more importantly to give some views on what we should be looking for when evaluating financial products.

Private Equity

If the banks really want to lend on a massive scale then funding Private Equity is one of the best ways to leverage up credit generation (and debt). Unfortunately, the banks liked this all the time the returns (i.e. profits) were good, but are now finding the going tough as the Private Equity companies find it difficult to make the repayments.

Mortgages

Another excellent way for Banks to get rich quick by increasing their loans and market share against an asset that supposedly never falls. Unfortunately, as soon as the economy takes a downturn, many of their borrowers can't make the repayments. The assets against which the mortgages are granted start to fall - Ouch!!!