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A flaw seldom mentioned

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Those wishing to become the next “worst prime minister ever,” have just hours left to declare their candidacy.  The Tory Party having just two weeks before parliament goes into recess to whittle the numbers down to just two names to be put before the wider Tory Party membership over the summer.  And in one sense, the old idea that anyone who says they want to be prime minister ought to be ruled out, is more true today than at any time in living memory.

The reason, bluntly, is that Britain is an economic basket case for which no cure exists.  Indeed, not only is there no palatable remedy, but nobody with the power of decision even understands the problem.  And for good reason – because our economists and policy makers are like the guy who lost his keys on the other side of the road but is looking over here because this is where the light is.  That is, as the late Immanuel Wallerstein was at pains to explain, data-gathering and publication is done primarily at a national level.  And so, decision makers tend to make decision based on what they think national statistics are telling them.  Worse still – although this is a secondary problem – since most of our statistics are “backward looking” – they tell us how things were not how they are – policy responses are invariably wrong… as is often pointed out, economic policy making is like driving a car by looking out of the rear window.

Take UK “inflation” for example.  Officially, inflation was running at 9.1 percent in May.  But here’s the rear-view driving problem – did it go up, down or stay the same in June?  And what is it doing now?  Well, the official answer to the first question will be published in a few days.  But we will have to wait until mid-August to answer the second question… and by then we could very well be in the worst recession since 2009.  And, of course, if that is the case, the Bank of England will likely still be making things worse by raising interest rates and exacerbating a generalised debt default.

There are deeper issues with “inflation” though.  The first concerns the definition of the word itself.  In its original meaning, inflation referred only to price rises resulting from an increase in the supply and/or velocity of the currency.  Hence the idea that “inflation is everywhere and always a monetary phenomenon.”  Nevertheless, there were several non-inflation causes of price rises – such as a poor harvest or a shortage of some good or commodity – which were not included in the original meaning of inflation.  The trouble for us today is that the definition of “inflation” has been expanded to encompass any price increase, irrespective of its cause.  And this has serious policy implications.

The standard – and wrong – explanation for big recent price increases is that governments turned on the printing presses and spewed out trillions of unbacked dollars, pounds, euros and yen in response to the pandemic.  The result is that as the economy has opened up, so all of that additional currency leaking into the real economy has driven prices up across the board.  This being the case, the obvious – and once again wrong – policy response is to dramatically cut the amount of currency in circulation.  Traditionally this is achieved using higher interest rates, which increase the cost of debt thereby bankrupting households and businesses, forcing up unemployment and crushing economic demand.  This makes the banks far less willing to lend new currency into the system.  Governments may also serve to lower the currency in circulation by raising taxes and cutting public spending.  Although – a common feature of neoliberalism – elected politicians prefer to hand unpleasant decisions to unelected technocrats in an attempt to duck the blame.

Not only is the standard narrative wrong, but because of the true – global – nature of the crisis, the received policy responses will exacerbate the problem.  Viewed internationally, we discover that we have almost exactly the opposite problem to the one which exercises national economists and policy makers.  Far from having too much currency in the economy, as the people of Sri Lanka have been the first to discover, we actually have too little.  Because, while the rules of the global economy are changing fast, for the moment we are operating under a version of the dollar system first introduced at the end of the Second World War.  And the currency we are short of at a global level is not pounds, euros or even Sri Lankan rupees… it is US dollars.

Surely not, didn’t the US congress just vote to create another multi-trillion-dollar stimulus package?  Well, yes it did.  But as happened every other time the state turned on the printing presses, almost all of those dollars rapidly found their way to the corporations and the banks, where they disappeared as pre-existing debt was repaid, or they have been left as assets on the balance sheets of the banks… none of which is in any hurry to be the next Lehman Brothers or royal Bank of Scotland.

The pandemic – and to a much lesser degree Brexit – has provided cover to those who would rather not admit just how bad things have been in the UK since the 2008 crash.  Although, as Richard Partington at the Guardian pointed out just prior to the first lockdown:

“The slowdown in Britain’s productivity growth over the last decade is the worst since the start of the Industrial Revolution 250 years ago, a dismal track record that is holding back gains in living standards across the country.

“Research from academics at the University of Sussex and Loughborough University shows that the productivity growth slowdown since the 2008 financial crisis is nearly twice as bad as the previous worst decade for efficiency gains, 1971-1981, and is unprecedented in more than two centuries.”

The average UK household is more than £6,000 worse off than they would have been if pre-2008 trends had continued.  Moreover, if things continue in the way they have since the first lockdown, average income is expected to go sharply into reverse.  And the main culprit in causing this the Bank of England – along with the other central banks – who’s post-2008 insistence that banks become ultra-cautious, while simultaneously providing bonds safer – because the central bank will act as buyer of last resort – than any real economy investment, has created a dearth of productive capital.

Lockdowns exacerbated the problem by artificially generating a massive crash in economic activity.  In the spring of 2020, it was nigh on impossible to find a corporate finance director anywhere on the planet prepared to authorise major capital investment.  And so, new production, upgrades and productivity improvements were put on hold for the best part of two years, during which time the just-in-time supply chains which keep the global economy afloat were stretched and shattered.

From May 2021, as economies began to unlock, the global economy ran into a perfect storm of real economy shortages in everything from oil to computer chips at the same time as dollar liquidity had all but disappeared.  That is, not only were prices rising because of the supply shock, but also because the US dollars which the world trades in had disappeared onto the balance sheets of banks and corporations.  The result is that the “normal” market response to a supply shock – investment in new or substitute production – could not occur because the productive sectors of the economy were – and are – starved of dollars.

Anyone getting their news solely from the UK establishment media will almost certainly not have seen this chart:

Prior to May 2021, the dollar had been falling.  But as the chart shows, there has been a dramatic increase in the value of the dollar in the months since… corresponding, of course, to the period during which so-called “inflation” has been increasing in domestic economies.  And the corollary, of course is that less tradeable currencies – like the British pound – have experienced an equivalent decline:

Strip out global and regional supply shocks in oil, gas, fertiliser and computer chips, and the remainder of Britain’s inflation is simply the result of the relative decline of the pound against the dollar.  And this is a serious problem for the UK in particular because it is a major importing economy which needs dollars to exist:

Notice how things have spiralled out of control since the peak of North Sea oil and gas production – a major source of dollar income – in 1999, and especially since Britain became a net importer of oil and gas in 2004/5.  Oil and gas aside, the main means by which UK governments have found the dollars they needed is through foreign investment in UK assets – aka privatisation – and by providing a safe means for non-USA dollar holders to launder their currency and avoid tax.  Nevertheless, there have been limits to both privatisation, money laundering and tax evasion, and these have been made up through borrowing.  At $9,623,468,400,000 as of March 2020, Britain’s (all sectors) dollar debt is by far the highest in Europe and, for comparison, dwarfs the $50,592,800,000 dollar debt which just crushed the Sri Lankan economy.

Superficially, raising interest rates should help resolve this imbalance by closing the gap between the pound and the dollar.  In reality though, this merely creates a currency death spiral since the aim would be to use the additional pound purchasing power to buy the dollars needed to repay the debt… something which – not least because most other countries will be doing the same thing – will ultimately raise the price of the dollar even further.  Moreover, with the Federal Reserve currently raising interest rates, and thus the value of the dollar, UK interest rate rises will crush the economy long before parity with the dollar could be re-established.

Even though this situation appears to benefit the USA as the dollar keeps rising, in the end it could prove catastrophic.  First, the high dollar makes US exports too expensive, bringing ruin to what remains of American productive capacity.  Second, in the longer-term it spells huge disruption and shortages as foreign suppliers of essential goods and commodities go bust in droves, adding hugely to the supply chain shock caused by lockdown.  Rather like the citizens of the Soviet Union in the 1980s, US citizens could find themselves with mountains of currency but no goods to spend them on.

There is nothing essentially new in the current situation, although details may differ from earlier dollar shortages.  The fact of the matter is that crises of this kind are a feature of the Bretton Woods dollar system introduced in 1944.  Then, the dollar was officially pegged to gold at $35 to the ounce.  But almost immediately, global shortages caused the true price of the dollar to rise much higher, as the rest of the world struggled to obtain the dollars needed to conduct international trade.  Then as now, one result was that American manufacturing became uncompetitive.  As early as 1947, the US government realised that they had to do something to provide dollars to the wider world if they were to avoid a domestic depression.  And so, the Marshall Aid programme was developed – ostensibly to help rebuild the war-torn economies of Western Europe and Japan, but primarily to flood the advanced economies of the world with new dollars.

The Soviet Union refused to play.  Leading first to the introduction of separate currencies in West and East Germany, and gradually solidifying the separation of the economic systems of western and eastern Europe.  Nevertheless, the Soviet bloc still needed dollars to secure the goods and commodities which couldn’t be produced within the Soviet sphere.  And so – to Britain’s benefit in particular – the Eurodollar system was born.  Soviet – and other unsavoury states’ – dollars could be deposited at banks outside the USA, where they couldn’t be sanctioned or confiscated.  The British web of anonymous offshore tax havens connected back to the City of London was particularly well placed to meet this need, providing the post-war UK economy with a new and unexpected if ultimately destructive lease of life.

Nevertheless, the fundamental flaw – that in times of crisis, dollar shortages emerge as dollars are funnelled away from productive real economy investment and into unproductive assets – remained.  It began to happen again as the phenomenal burst of post-war growth slowed in the late 1960s and came to an inflationary halt in the early 1970s.  The infamous result was Nixon’s forced, “temporary,” end of the gold standard in August 1971.  The lesser-known consequence was that, rather like domestic banks, certain select banks outside the USA began to create Eurodollars of their own, independently of the Federal Reserve.  And again, like the domestic banks, they gradually abused the privilege, creating rafts of derivatives which depended upon a growing volume of dollar denominated debt to prevent the system from imploding.

If this looks a lot like the situation in the years leading up to the 2008 crash, it is because it is.  Except that there is growing concern that instead of running securitised investment vehicles and collateralised debt obligations based on billions of dollars’ worth of mortgages, since 2008 the global banking and finance system has created trillions of derivatives based upon all of the outstanding – and increasingly unrepayable – global dollar-denominated debt. 

What is new this time around is that the oil shock of 2005 which triggered the series of policy mistakes that brought down the banking system in 2008, has morphed into a generalised supply shock in 2022 as the energy cost of energy is driving up the value of essentials like food, fuel and temperature control, even as the larger, discretionary sectors of the economy are already in recession.  This can sound technical, but what it means in practice is that there are ever fewer real economy investment opportunities.  This, in turn, means that the banking system is not creating the dollars (internationally) needed to maintain real – non-financial – economic growth.  Lockdowns worsened the problem, but they are not the cause.  Nevertheless, as we are discovering to our cost today, after 2008, and especially during two years of lockdowns, new mines did not get dug, oil and gas deposits went undrilled, chemical feedstocks were allowed to deplete, firm electricity generation went unbuilt, factories were never set up, and the incomes of productive workers and businesses were allowed to atrophy. 

Only the oligarchs and corporations sucking on the teat of central bank handouts were allowed the fiction of financial growth… and only then provided that none of it leaked into the real economy.  But even this “paper” wealth – largely based on trillions of hypothetical dollars in derivatives – will evaporate before our eyes as international debt becomes unpayable and as a host of states around the world follow the path being laid down by Sri Lanka.  Nor is the coming sovereign debt crisis limited to the third world.  There is every likelihood – barring continued German self-immolation – that the UK will be the first of the G7 economies to collapse.  Not least because of the UK’s rash response to the Russian invasion of Ukraine. 

For much of Britain’s history, its leaders were smart enough to recognise that, appalling as war always is, in most cases foreign wars should be considered none of our business.  The conflict in Ukraine is “a quarrel in a far away country between people of whom we know nothing,” as evidenced by Foreign Secretary Truss’ apparent early belief that Ukrainia was an island in the Baltic Sea.  But unlike the conflict those words were originally uttered about, and for all of the establishment media bluff and bluster to the contrary, Putin is not Hitler, and the incursion into Eastern Ukraine is not an existential threat to Britain, Europe, or even the former Soviet states in the East of Europe.

What really is an existential threat to Britain – and, indeed, to the western empire as a whole – is the ill-conceived sanctions salad which has destroyed the basis of the Eurodollar system itself.  By sanctioning the Russian central bank and, crucially, by helping ourselves to the assets of individual Russian oligarchs, many of them ambivalent to the fate of the Putin government, we have destroyed the very reason that these assets were parked in London in the first place.  If London, along with the smaller European banking centres, is no longer a safe place to park dollars outside the USA, then there is no point in seeking to hold and store dollars at all.  Far safer – if not better – to convert them into gold or commodities.  And if, as is now accelerating, an alternative commodities-based currency was to emerge from the BRICS, why not use that instead?

Domestically, the fall of Boris Johnson and his eventual replacement by one of about a dozen nonentities unfit for much more than an assistant manager’s job at the local housing office, is no more than the mould on the skin of a neoliberal apple which is rotten to the core.  The same, of course, goes for the potential replacements for an increasingly unpopular president on the other side of the Atlantic.  None grasps the enormity of the crisis before us.  And the policies on offer serve only to exacerbate the crisis.

In the past we could always count that “cometh the hour cometh the man.”  This time around though, we are on our own.

As you made it to the end…

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