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When the rain dance fails

There are two ways in which a government can create new currency.  They can borrow it into existence through the sale of bonds or they can instruct the central bank to spirit it into existence directly.  During the two years of lockdowns, the UK government did both.  And not on a minor scale.  Billions of new pounds were created to keep businesses and households afloat at a time when a large part of the economy was shut down – quite literally, money for nothing.

The new currency helped increase online retail sales, along with creating a mini-boom in the summer of 2020, when brief re-openings allowed a degree of pent-up spending as people rushed to buy new clothes, get a haircut, and enjoy a meal out and a pint down the pub.  But the biggest impact of the new currency was on savings, as people found themselves with money in the bank but few opportunities to spend it… and this was bad news for the economy when it was finally allowed to reopen.

If the new currency was the only economic force at play, central banks might have engineered a “soft landing” if they had begun to raise interest rates immediately – something the Bank of England was later criticised for failing to do.  However, the original prognosis of temporary inflation was probably correct.  The problem was with the lack of definition of the word “temporary.”  If – as appears to be the case – the Bank of England economists imagined that the retail spending spree in the autumn of 2021 would mirror the brief spree in 2020, they were badly mistaken.  That spending spree had been brought to a rapid end by the re-imposition of lockdown as a new wave of Covid struck.  But no lockdown occurred in winter 2021, allowing the spending spree to continue and, indeed, to become self-reinforcing – higher demand, shortages, and rising prices encourage consumers to buy sooner rather than later… using credit if need be.

The growing crisis by 2022 though, lay beyond monetary and financial policy.  The lockdowns had wrought terrible damage upon global supply chains resulting in largely unpredictable shortages – empty shipping containers piling up in the wrong ports, key components unable to reach the factories which needed them, a lack of truck drivers to move goods around, etc. – which created supply-side price increases.  And if that wasn’t bad enough, following the Russian invasion of Ukraine the UK government (along with the Europeans) embarked on a self-destructive economic war on Russia which has backfired spectacularly, leaving the continent short of energy and raw materials, and forcing prices higher as alternative – and higher cost markets have to be accessed.

It was this series of supply-side shocks – similar to the oil shocks of the 1970s – which held prices higher for longer.  And in the face of growing public and political pressure, the Bank of England blinked – raising interest rates at the fastest pace ever.  While the interest rate itself is far lower than it had been in the 1980s, when measured against relative incomes and prices, the coming interest rate shock is far greater than the one which turned the recession of the early 1980s into a full-blown depression which wrecked the UK economic base… something it never fully recovered from.

There is, of course, a degree of lunacy about the way in which interest rates have been raised.  If the central bankers knew what they were doing, they would surely have raised the rate immediately to 5.25 percent (assuming that is where they believe it needs to be) rather than making small monthly incremental steps.  After all, it takes months and even years for interest rate rises to have an impact on household and business spending, as we are mostly locked into two-, three-, and five-year fixed interest loans.  And it is only when these have to be refinanced that the full impact of rate rises is felt.

Relying on backward-looking data (and probably for psychological reasons) the Bank of England is playing down the growing evidence of an impending crash.  They admit that “The full impact of higher interest rates has not yet passed through to all household and business borrowers.”  But then they reassure us that:

“Although the proportion of income spent on mortgage payments by households is expected to continue to rise through this year and next, it is likely to remain below the peak observed before the in the Global Financial Crisis in 2007.

“The number of home-owners who were behind in paying their mortgages has risen modestly, but this remains low by historical standards.

“Some mortgage holders facing higher interest rates have extended the period over which they are repaying their mortgages, with a small number moving to interest-only deals.  While this eases pressures for these households in the short-term, it could result in higher debt burdens in the future…

“Overall, we expect UK businesses to be resilient to higher interest rates and weak growth.  Smaller businesses and those with relatively bigger debts are likely to struggle more.  The number of business insolvencies has continued to rise.  This trend has been largely dominated by smaller firms so far.”

Bigger companies are less impacted by interest rates because they are locked into longer fixed interest loans.  Although there may be a degree of complacency here because they are still vulnerable to the coming decrease in demand as households and smaller businesses have to rein-in their spending.

There is also a considerable degree of optimism behind the assumption that banks will be prepared to re-finance businesses and households which are struggling to meet official loan-to-value rules.  A sizable proportion of the 1.4 million households rolling over their mortgages over the next nine months may find themselves on the far higher standard variable rate which – assuming they cannot keep up the payments – will be a precursor to default and compulsory repossession.

Not that official bankruptcy can happen immediately.  Various legal proceedings are required to formally declare a household or a business officially bankrupt.  Which points to another area of complacency in the official Bank of England position.  In August 2023, company insolvencies hit 6,342 – the highest since 2009.  This dropped slightly in September, but is still above the 2009 level, and most worryingly is hitting businesses across all sectors of the economy:

Most of the insolvencies are “voluntary” – company directors effectively throwing in the towel rather than waiting for one or more creditor to take them to court.  But within the data is an alarming rise in “compulsory liquidations” from 504 a year ago to 735 in Q3 2023.  Although small as a proportion and – as the Bank of England has it – mainly affecting small and medium companies, the reason this should be taken seriously is because of the time delay involved.  Given that the civil courts have yet to clear the lockdown backlog, it is safe to assume that these businesses are the tip of a growing iceberg, since they got into trouble either prior to or in the early stages of the rate rises.

Technical bankruptcy across Britain’s local authorities is also emerging as another facet of an “everything crisis,” which probably cannot be overcome but merely adjusted to.  Because – ultimately – local councils are backed-up by the UK government, and because a sovereign government can – technically – print its way out of debt, these councils – which may also be the tip of a bigger iceberg if interest rates do stay higher for longer – will continue to function but will be obliged to cut services and raise local taxes.

Doing this at a time when businesses and households are already struggling, however, is counterproductive as it will drive more businesses and households into bankruptcies whose affects include placing further demand upon local council services and support.  The alternative of central government borrowing to bail out councils is no less palatable because of a flight from government bonds which could morph into a sovereign debt crisis if governments like the UKs cannot credibly demonstrate that they have a plan for growing the economy and gaining control over public debt.

Given that the UK’s uniquely bad problems are occurring against a backdrop of a globally synchronised economic slowdown and currency shortage, it is entirely likely that we are about to be treated to something at least on the scale of 2008… if not worse.  And when the proverbial hits the fan, senior officials at the Bank of England will likely be held responsible.  Not least because it will be an election year and an incredibly complacent – incompetent – UK government will be desperately seeking to deflect the blame.  In part, the Bank of England officials – many of whom are paid in excess of £250,000 per year – deserve what is coming, since they have maintained the pretence that monetary policy alone can resolve a crisis which has far deeper supply-side problems.  And perhaps it was fear of losing those high incomes – along with the status and privileges which go with them – that caused them to hold their tongues when they should have called-out government fiscal policies which have been at odds with the UK’s economic interests.

There again, economists and central bankers have been all too similar to so many ancient cultists engaged in ineffective rain dances, ever since they drew the wrong lesson from the early 1980s – attributing the cause of the depression to the brave deeds of St. Paul Volcker rather than seeing its true cause in the deflationary impact of rising oil prices resulting from the Iranian revolution and the Iran-Iraq war… something which, by the way, will look trivial if Russia were to really cut off the oil and gas (it currently arrives via third countries) or if Iran is provoked into closing the Strait of Hormuz – two “black swans” which could make the storm which is unfolding much much worse.

As you made it to the end…

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