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Recession guaranteed

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Not only is Theresa May’s magic money tree real, but it just produced a really bad harvest.  To understand why, we need to understand what makes modern currency valuable.

It used to be that coins actually contained precious metals.  Then, when banknotes first appeared, they could be exchanged for precious metals.  Later, cheques could be exchanged for either banknotes or coins.  As recently as the 1970s, governments maintained the fiction that there was some quantity of gold and silver sat in a high security vault, against which the currency in circulation was balanced.

Today, however, there are just two laws that give currency a value: you must pay your taxes in the official currency, and traders must accept the currency as legal tender.  Since these are laws laid down by government, it follows that government is what gives currency a value.  Thus, governments really do have a “magic money tree.”

There are limitations, of course.  Print too little currency and you stifle economic growth.  Print too much and you get inflation.  Print currency while you are running a trade deficit and you risk a run on your currency (which may result in hyperinflation).  Broadly, however, a government could mandate that purple stones are now currency with which taxes are to be paid and transactions to be made, and we would all be obliged to start earning purple stones.

Today almost all of the transactions – including the payment of taxes – in the economy are electronic.  Notes and coins make up less than three percent of the currency in circulation and are used in less than one percent of transactions.  This is important to understand because, while governments create the notes and coins, the electronic currency springs into existence every time a bank makes a loan.  This means that the rate and volume of new loans determines how much currency is in circulation at any time.

New debt-based currency flows into the economy in two ways:

  • Government borrows to fund public spending
  • Businesses and households borrow to invest and consume.

This influxes of new currency are counteracted by two equivalent out flows:

  • Government collects taxes
  • Banks collect repayments with interest from businesses and households.

A key condition for economic growth (but not the only one) is that the supply of currency grows at the same pace.  Too little new currency leaves businesses starved of capital.  Too much currency results in inflation.

The problem with this in practice is that nobody knows where the currency Goldilocks zone is located at any time.  All of the data used to measure the health of the economy is “backward looking.”  For example, sales figures or jobs reports tell us something about what the economy was doing three months or more ago – and even these figures are provisional and liable to be adjusted.  It could take six month to a year before we can even estimate what the economy is doing at this moment.

The result of this – probably intractable – problem is that governments and central banks that attempt to intervene in the economy often end up doing the very opposite of what was intended.  In the lead up to the 2008 crash, for example, central banks believed that there was too much currency in circulation and that this was beginning to cause inflation.  In response, they pushed up interest rates.  This policy succeeded beyond their wildest dreams – by crashing the economy and creating the worst depression since the early 1930s, they have succeeded in crushing any and all price increases that might otherwise have occurred.

Governments and central banks are doing the same thing again today.  With commodity prices increasing and stock markets at an all-time high, politicians and economists have convinced themselves that the economy is doing well.  In response, interest rates are rising and stimulus packages are being unwound.  In the UK in particular, this is being done at a time when an ideologically-driven government is also lowering the amount of new currency it spends into the economy.  In the USA, the role of government is more complicated.  Tax cuts and infrastructure programmes may serve to offset some of the effects of Federal Reserve monetary policy.  However, critics of the recent budget point out that too much of the new currency is being given to wealthy individuals and large corporations that are both far more likely to pump it into already dangerously inflated asset bubbles rather than investing and spending into the real economy.

What we do know is that while the City of London and Wall Street are booming, the High Street is falling apart (figuratively and literally).  Barely a day goes by when one or more retailer goes into administration or issues a profit warning.  While I have been writing this article, one of Britain’s oldest mail order companies, Kleeneze, has gone into administration.  This follows the recent closure of chains like Maplin, Bargain Booze and Toys R Us.  Even stores whose sales figures have been holding up have been forced to cut employment to keep costs down.  In January, three of the UK’s biggest supermarkets – Tesco, Sainsbury’s and Morrisons – announced more than 5,000 job losses.

The spurious reason offered for this by mainstream media is that “Amazon did it.”  Certainly, online sales have increased as more households and businesses seek to lower their spending.  But the growth in online sales is but a small fraction of the loss of sales on the High Street.  The reality is that as commodity prices and interest rates have increased, households and businesses have had less currency to spend on discretionary items.  In the UK, real wages (adjusted for inflation) have stagnated for a decade.  As a result, the balance of spending has shifted away from discretionary items toward essentials like food, utilities, rent/mortgage payments and debt servicing.

Indeed, the trend has been obvious enough to anyone paying attention for several years now.  At the very bottom of the income ladder, we have witnessed an explosion in the number of emergency food packages provided by a growing network of foodbanks.  More recently, we have seen an alarming rise in homelessness as families fall too far behind with rent and mortgage payments.  These, however, are only the more obvious signs of impending problems.  A more subtle indicator appeared at the end of 2016, with news that Britain’s personal hygiene purchases had changed – people appeared to be washing their hair and taking showers less often; and when they did, they used cheaper soaps, shampoos and body washes.  This indicator seemed so inconsequential that few in the mainstream media picked it up.  However, As I wrote at the time:

“In the grand scheme of things, shampoo sales look trivial.  Brexit, Donald Trump and the rise of the European far-right all look far more urgent.  But the political froth that is currently manifesting in the form of right-wing populism is merely the product of seismic shifts in economic processes that were put in chain decades ago.  In something as complex as a global economy, it is precisely emergent behaviours – like a shift in people’s personal hygiene habits/preferences – that signal that the tectonic plates are shifting once more.

“[However] The problem is not with the personal hygiene products, but with the infrastructure that we depend upon to purchase them.  Supermarkets have for decades used our collective spending power to beat down the price of all of the goods – including soap and shampoo – that we buy.  The same supermarkets have seen a generalised curbing of discretionary spending across the economy.  Perhaps most importantly, we now generate less than a third of the food waste that we had done before the 2008 crash.  Austerity has caused enough of us to buy less and to manage more of what we buy to the point that this is impacting on supermarket profitability.  The shift in shampoo and soap sales is just another manifestation of the problem.”

Shifts in discretionary spending patterns begin a domino effect in which businesses that retail, import and manufacture discretionary goods and services find themselves under increasing pressure.  To some extent, job cuts and shifts in work practices – like those implemented by the supermarkets earlier this year – can stave off the moment of truth.  But unless discretionary spending increases, sooner or later – as in the case of Toys R Us – closure becomes inevitable.

The real problems kick off, however, when the shift in spending patterns begins to affect non-discretionary spending.  This is what the growth of foodbanks and homelessness is warning us of – they are like the canary in the mine, signalling imminent danger for the wider population.  The more alarming recent indicators, though, are to be found in the sudden plunge in two key markets; housing and cars.

These are not only an example of declining spending shifting from discretionary to (at least semi-) non-discretionary items; they also spell a collapse in the supply of currency in the economy.  For most families, a house and a car are by far the most expensive items they will ever buy.  More importantly, in very few cases are these two items ever paid for in cash.  As such, they are two of the most important means whereby debt-based currency enters the economy.  So, a sudden decline in the sales of both cars and houses signal an imminent monetary deflation that will inevitably lead to business failures and job losses.

Importantly, we do not need an absolute fall in borrowing to trigger a recession.  A fall in the rate of new debt is sufficient to trigger a recession or a complete collapse similar to that of 2008.  Moreover, in the real world, people respond to the onset of recession in an economically counterproductive way.

In the wake of the 2008 crash, US President George W. Bush urged Americans to go out and spend.  But that is not what people tend to do because it doesn’t make sense.  Faced with the onset of recession, households and businesses tend to cut spending and repay outstanding debt.  The trouble is that just as new currency is created when people take out loans, so it is destroyed when they repay them.  So a fall in the rate of new borrowing coupled to a rise in the rate of repayment serves to amplify the recession.

In the UK at the start of 2018, this is exactly what we are witnessing.  The trend is most obvious in the index of M3 money – the broadest definition, and the one that governments and central banks use to determine policy (the same trend can also be seen in M2, but it is not so pronounced):

According to Kevin Peachey at the BBC, these indicators could derail the Bank of England’s plan to increase interest rates in May:

“Across the UK, 9.2 million households have a mortgage. Of these, about half are on a standard variable rate or a tracker rate, and they would most likely be affected by a rise in the Bank rate.

“However, these figures, as well as an unexpected 0.2% fall in UK manufacturing output in February, do mean that the UK economy may not be growing as fast as predicted, making an interest rate rise less inevitable.”

In effect, the interest rate rise last November may already be having a negative impact on the UK economy.  However, the decision to unwind quantitative easing and to increase interest rates is not “data dependent” but political.  Along with the European Central Bank and the Federal Reserve Bank, the Bank of England believes that is needs to raise interest rates to around 3% to provide itself with the ammunition (i.e. rate cuts) to cope with the next economic crisis.  The alternative – to no longer be able to respond – is politically unacceptable; and the fact that raising rates into a gathering recession may actually generate the very crisis they seek to avoid simply cannot be entertained.

It is not beyond the bounds of possibility that we will soon hear the Bank of England Governor, Mark Carney paraphrasing an anonymous US Major following the bombing of the Vietnamese village of Ben Tre: “It became necessary to destroy the economy to save it.”

As you made it to the end…

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