The Economics of Debt

Any small businessman will tell you that debt is a huge burden. It is not only that the interest cost is a drain on money that can otherwise be invested but it is the notion that once you have a debt, it is damn difficult to get rid of it.

Other businessmen think debt is fantastic. From it you can leverage huge profits and it is the principle behind many private equity fuelled buy outs. For a small capital outlay, vast sums of money can be borrowed to buy companies which can be later sold with a disproportionate amount of profit from the risk going to the private equity house. In the purchase of Boots, private equity outlayed less than a few hundred million while raising £9bn.

Debt, in that sense is good. Philip Green used a pile of debt to pay himself a one-off dividend of £1bn tax free. Debt, in plenty of senses then, is good.

But for the average business, the problem with debt is that it has to be productive in terms of increasing profits. Without a huge boost to profits, cashflow does not sustain the interest payments and so you have to borrow more in the hope that your business will catch up. In the end, it can be good money after bad as the implosion inevitably comes as the debt gets ahead of the business. For small businesses, debt is only good for working capital and generating more cash, beyond that it is a millstone.

So how do Government's view all this? The US just closed out its fiscal year with $1.4 trillion of debt, the highest national debt since 1945. As former Head of the Fed, Alan Greenspan, observed this is the most worrying aspect of the US economy. The equations start getting explosive in his eyes as more money is required to pay interest on the debt and you end up borrowing more just to pay the interest - the priority has to be to bring that debt down.

There are a few ways to do this. First up, you can get the economy growing, which is why there is so much debt there at the moment as the US tries to use more debt to stimulate the economy. This is exactly Greenspan's issue - using debt to stimulate growth can go horribly wrong and it's exactly what small businesses fear - if the revenue streams do not come through fast enough to bring much needed cash, then pretty soon you end up borrowing more. The second way, is to sell assets which has been the recent domain of the UK Government. The problem is that beyond gold, countries usually do not have easily 'liquifiable' assets. In Britain's case, we no longer have large golden stakes in large companies, we have the stakes in the banks but they are all still under water while other things like buildings and debts are not so easily sold. One thing we did not have was gold to sell. Such asset sales, as a small businessman would know, tend not to add much to the coffers to reduce debt - in our case it may be a few company cars, maybe a building, furniture or plant facilities. Asset sales of this type are usually done in desperation, like pawning jewellery in the face of credit card debt. Inevitably you are a buyer's dream and so you will never get full value for your assets as the British Government will soon find out.

Further, selling assets as a business means you have less to bargain with for the future and for a Government, once it is sold that's it - gone. The final way to make inroads into debt is to make cuts in the budget. Small businesses know all about this. Wastage is the first port of call but usually there is not a massive amount of 'wiggle room'. Certainly, the end of month pizzas may go, fresh flowers in reception, travel is fairly game forcing salespeople and managers to think hard before travelling and then looking levels of spend on things like flights and hotels. Then it gets nasty - the biggest expense for small business is the salary bill and that's where cutting can produce real savings. Of course, you are affecting your future capabilities but needs as must - for my money, it should always be the last port of call.

And so to Government. I argued yesterday that cuts can be made very easily - when you look around at the multifarious layers of Government and the associated lackies and cost, long before you start affecting public-facing services, you have vast layers of expense which are pure wastage. This is an easy starting point for Government and savings can be realised very quickly by canning external advisers, consultants, halting project overruns, getting rid of contractors, looking at layers of management and getting rid of many of them.

It has been pointed out that this recession has been felt almost exclusively in the private sector and that the public sector has done nothing to rein in cost, eliminate wastage or make cuts. Thus, the majority of the newly unemployed have come from the private sector. Yesterday, we saw positive results on the unemployment number as the rate of additions to the total seemed to slow and this had a small positive effect on the budget deficit forecast for the month. This could be a false dawn as the Government are going to have to start making some serious cuts - very soon and that means people hitting the dole queues from the public sector. It's crazy that it hasn't yet happened - but it has to.

My point in all this is that as small business people we know the economics of debt. It is a bad thing, particularly when markets are depressed. You can borrow in such times but it is usually out of desperation when in all reality, you should be cutting your cloth. Spending money in the hope things will come good, without a great plan for finding ways to grow, usually ends in tears as interest payments mount.

Alan Greenspan knows a thing or two about economics and I think he is right. Debt is know reaching the critical point - Britain is spending in the hope of an upturn and spending big. While you have to spend money to stimulate, you have to realise that in the background you have to make essential cuts.

It isn't as if we cannot survive if cuts are made - Britain is a bureaucratic monster with one of the heaviest public sectors in Europe. If we cannot find efficiencies in this structure then we ought not to be in Government, because as small businessmen we can see it all too easily.

The public sector is too big, too fat, has overly generous pension schemes and is a huge burden on our taxes and business - it has grown vast, inefficient, multi-level departments, which are mini-governments in themselves, over the last 12 years that has spawned regulation after regulation culminating in the last tranche of the farcical new Companies Act just last month which was years in the making, issued in 3 almighty sections and added really just 4 things of note to over 97% of the number of companies in Britain.

The waste is just awesome and shameful - and it needs to be cut, and fast.

Is There A 'Real World' Anymore?

I hadn't realised that there was a famous Economist who has been credited with predicting the world financial crisis. There is one and his name is Nouriel Roubini, from a New York University.

Although I know of several people, including myself, who reasonably accurately predicted that there would be, in my own terms, 'A hole in the economy', largely as we believed that asset values had lost all connection with the world's voracious creation of money, we had no idea of the real technical issues. There was one other minor problem - none of us were world famous or economists and therefore we were not allowed to have such opinions, express them in public or have any credence attached to them. That's just a fact.

In fact, even as a shareholder in RBS, Lloyds, Northern Rock and Bradford & Bingley I have no say as that shareholding is managed on 'our behalf' by UK Financial Investments plc, a company that has not issued share certificates to any of us or in which we have any rights to vote. I have an unnerving feeling that we probably will not not get full value for our 'stock holdings' as the staff associated with that company will not only get a salary but bonuses too. Just like the FSA who received bonuses to a person as the world economy melted down on their watch.

But we should be grateful, because the politicians who did not want my opinion then do not want them now - not because I would probably start each sentence with, 'I told you so' but because they really could not give a flying fig what people like me think, even if we are vaguely right. We are the 'programmables' - the people who are fed the information and soundbites and duly absorb and believe them. In a single weekend of spending our future tax to an extraordinary and unprecedented extent just to save the skins and bonuses of a group of greedy bankers to the tune of £1.5 trillion, the Government now believe that the enormous debt burden they have put us all under can be halved by 2014. Yeah, right.

It's complete cod's wallop and I know it. But they rely on the fact that no one will listen to me as I am not a world renowned economist and nor is anyone else in the front bar of a pub.

I have talked about Joseph Stiglitz before. He's not a personal friend, and you probably would not like to get caught in a lift with him, but I feel a kind of kinship with the Nobel Laureate for economics as he could have come into the front bar of most pubs and been greeted warmly as a person who we might have described as not having his head up his arse. And so too Nouriel Roubini. Again, I probably wouldn't recognise him if he walked into the White Lion in St Albans. I might have even nudged a friend and nodded toward him and said ,'Isn't that the bloke off Bergerac' and gained 10 points for a good lookalike, but if he joined into our conversation then we may forgive him that he knew nothing of rugby but as long as he could name at least 5 films with a memorable song in them then he probably would have got a fair hearing. If he spoke of the economy, then I would expect a hearty pat on the back and a pint of Black Sheep would be bought for him. Assuming, of course, that even a lowly economist would stump their round at some point.

Roubini is supposed to have predicted this financial meltdown. He also points out that we are not out of the current financial crisis yet as the world economy looks very weak - his words not mine but, without blowing my own trumpet, I would agree. He claims that in a general sense shoppers are 'shopped out' and 'debt burdened' - this despite the fact that last month saw the first reduction in the £1trillion unsecured debts that UK consumers have for years. Roubini believes that we all should 'cut back consumption and save more'.

Hear, hear from the front bar. Wise words, another round on the slate or my debit card, please. What? I can't have credit? Well Roubini then goes into techno-speak claiming that the financial system is damaged and that not much corporate spending on capital is going on. That's true - and most companies are reining in expenses too as credit is scarce as well as the markets depressed.

But here comes the real blow in his message. He reckons that US house prices have yet further to fall. That's a worrying comment as the problem of inflated asset prices was far more acute in the UK than in the US. Our prices had soared uncontrollably over the last 10 years and our drop has only really been 20% or so during the crisis. Enough to send everyone into a panic and many into negative equity exposing the stupidity of the markets for buying debt but there you go. So Roubini is saying we have not seen enough of a fall in house prices yet - that's really bad news. It's really bad as that is just about the only financial instrument that has propped up the economy for the last 10 years and is currently our barometer for recovery. Wages have fallen over that period and so household income in real terms fell, but we leveraged our rising assets a great deal to supplement our spending spree.

We lost sight of the 'real world' where you only spend according to what you earn. We participated in a new 'unreal world' where we all discovered the new banks - our homes - and the world of cheap credit it released. So when the financial system went into meltdown, our homes were right in the middle of it.

You see, while property prices in the US have fallen just 13%, there has not really been a corresponding spread of price decreases into the commercial property market. That would cause chaos as that is where the big pension funds that we invest in for our future have all the money. The chaos so far has affected those who largely backed only the housing world. Should the price of commercial properties also fall, then we will have a very gloomy world to live in.

Roubini clearly has, at some time, been in the front bar of a pub as he believes the current 'froth' in the world markets which has seen the FTSE rise some 40% in a year is due to the manipulation of the Federal Reserve and the Bank of England. As Roubini puts it, "There is a wall of liquidity cashing assets, but I think that there is a growing gap between what is the asset prices and the real economy."

The 'real' economy. The real world. That's really the issue. This is why armchair sages like me struggle to communicate our thoughts - we have no formal economic education, I am a humble scientist by training and a salesman at heart. The economy is something that I glaze over when people start mentioning the 'Broad Money Supply' and, to me, M4 is just a motorway I use to go and see my family in Wales.

But Roubini is right. We have disconnected what are the underlying economic things from the new world order where we can create money out of nothing, profit out of profit. Even our solution to the problem compounds it all as we create money out of nothing to buy our own debts as Quantitative Easing has done. There is a real concern in the US that Government Bonds will not get bought as interest rates are too low. Meanwhile, when our Government stops buying its own debt with fake money, will there be a market for our bonds?

What the solution to the global economic meltdown has been, across the board, is an exercise in saving a small number of wealthy individuals' careers and re-fund them to make more money for the future. In doing so we stopped a collapse that could have taken us all with it that's true, but in reality we have just resupplied these individuals with the means to carry on creating more of a fake economy, very distant from the real economy.

Instead of these individuals using our precious cash to provide credit to business they have used it to buy the reduced value 'toxic' debts at the very companies that crashed in order to rekindle the whole fake economy and get their bonus train going again, making vast profits from effectively barrow loads of manure - worthless debts. The one thing that could really exaggerate all this is if house prices do start to rise because this will just get us all back into the groove and contribute by withdrawing from our equity and forgetting that in real terms we are getting worse off - as we forgot for the last 10 years.

The likes of Roubini and Stiglitz are the 'turds in the swimming pool' of new economic thinking. Stiglitz may have offered his advice on the solution to the global economic problems for free but that was his mistake - Credit Suisse knew the British Government was willing to pay and so they made sure they bid accordingly and have been paid handsomely for their advice. You see, in the new world of economics your value is not perceived by the number of Nobel prizes you have won but by the pounds you can bill or the value of your bonus. Porsches and Bentleys count in that world and that's what Gordon Brown asked for and got. So it's little wonder that we have a set of solutions which effectively threw enough faeces against a wall until some stuck in the form of incredible sums of money instead of resetting the 'real' economy by making sure banks did what they were supposed to.

But that is the issue. The banks have carte blanche to carry on as before. Oh yes, we can posture about bonuses, we can moan about imposing taxes, we can even supposedly turn on our friends as Peter Mandelson has done and accuse them of the very things he applauded, benefited from and whose advice he has paid for not months ago, but until you get to the root of the problem banks will carry on producing a fake world in which only a very few benefit and the world becomes a far more precarious place to live in.

Has, indeed, the fake world of the new financial order taken over from the ;real' world of fundamental economics of supply and demand?

If we do not reform the whole banking industry, there will be more than money to pay in the future - as Roubini puts it, 'We are already planting the seeds of the next crisis'. At the heart of it is the stability of the world as, if the financial system does break to an extent where mere money cannot repair it, then those with the most valuable commodities will rule.

My God, David Icke WAS right.

Lightening Can Strike Twice

It is very unsusual that anyone agrees with me, even my wife, so imagine my surpise when I read that no lesser sage than former Federal Reserve boss, Alan Greenspan, goes on TV to agree with me.

Ok, so he didn't actually mention my name but he all but did. He was interviewed by the BBC for some series and he said, and I quote, 'The crisis will happen again but it will be different.' See, I told you so. Those eagle-eyed readers will know that I have repeatedly, not once only, said that the way we have dealt with this crisis has only papered over the cracks and so it will recur. Now two experienced individuals have publicly agreed with as I number Joseph Stiglitz, Nobel Laureate as another. He, again, rather strangely omitted my name in his announcements but the gist was the same.

Pedants among you will note that Greenspan is observing dryly that economic crashes come after prolonged periods of growth - and that is inevitable. That is not quite what I said - in fact, I said something very different but, heck, the result was the same. Greenspan even goes onto to say that sub-prime may have triggered the current crisis but it could have been any other of the weaknesses in the system that could have brought it on. In a roundabout way this again agrees with my personal thesis and I suspect for the same reasons this time. Sub-prime was just a manifestation of a flawed system. I think that's what Greenspan is saying and he probably nicked the idea from me.

Reading the article more thoroughly reveals that his opinions are pretty different and frankly, that's because he knows what he's talking about whereas I am guessing. However, it wasn't a bad guess - take note, Gordon, that plumb job as CEO of UK Financial Investments is up for grabs and I think anyone who gets even half of what Greenspan thought of right needs to be considered seriously particularly if there are nice bonuses associated with the job, old chum. Greenspan goes on to say that he thinks regulation should focus on fraud and capital requirements at banks to get them back on track.

To be honest, the sentiments are echoed by a real banker. I said banker, actually. Stephen Green, Chairman of HSBC, who has just levied a £25 per month on my HSBC Bank Account without warning and for no apparent reason, has actually come out and admitted what Adair Turner was barking on about the other day was right. Turner was two steps closer to the Funny Farm when he suggested that many of investment banks' activities 'served no social purpose' and Green may have saved him from the padded cell by agreeing. Further Green says that 'excessive' bonuses should be stopped too. I bet he got some nasty stares from his whizz kid traders when he got into the office today.

What Greenspan and Green are saying is that banks need to focus more on their core activities and make sure their basic fundamentals are right. In a much less reasoned way, I have said the same to anyone who would listen. Green says that 'Some parts of our industry have become overblown, and certain products and services failed the tests of usefulness, suitability and transparency'.

I think what Green is saying fits in with Turner's assessment. My personal take was that I think many products that banks traded so excessively in the last 10 years have been out of touch with any reality and I would assert that the profits made came out of thin air. Quite literally, taking one of these products as collateral to a restaurant to the pay the bill would be no better than me offering my lottery ticket to the waiter and saying this £1 ticket is for payment and you can have whatever it is worth as payment for the meal. The waiter would have a reasonable chance the ticket is worth £10 but a 1 in 14m chance it was worth a jackpot, plus all the probabalities in between. But the highest likely option would be that the ticket was not worth anything. Imagine the waiter taking that ticket and it being traded many times and each time the people who traded take some real money from the other party in return of a chance of a jackpot. Pretty soon, the ticket will have been traded so many times that whatever it is worth will never pay for the price paid. The trades have nothinbg to do with the ticket's worth.

It may be a bad example but it is not far off the truth. Some of the products the City trades serve no earthly purpose other than to line the people's pockets who trade them.

So I would stick my neck on the line and say to Greenspan, 'Actually, Alan, you are wrong. The crisis we saw did not come as an inevitable consequence of a prolonged period of prosperity, it came as a result of the vast increase in trading of spectulative products that had lost all touch with their origin and so were generating virtual, not real profits.'

I would further assert, that until we ban such products being traded, we will endure another cycle of fictional prosperity and spectacular bust bigger than before - unless we change the system fundamentally. It isn't about regulation and it isn't about capital reserves - it's about what banks trade. Sort that out and we get of that problem until they invent the next scam to make money. And one last note on this for all those virtual reality merchants in the City - the talent they so loyally protect, who they believe should have the freedom to earn as much as they like, have been trading only make-believe products. Frankly, any kid could have done it who had played Monopoly.

It's some day when you realise all the tripe you have written actually is getting close to the truth. Greenspan and Green, I salute you.

Out of Thin Air

Quantitative Easing is a funny old thing. It's effectively creating money out of thin air and it is currently seen as the method to rescue the global economies. It's such a great idea, it's a wonder that we don't do it ourselves - individuals that is.

But we have. More of that later.

The US Announcement

The theory goes that money, like matter, cannot be created or destroyed.

That's not entirely true. Today, the US Federal Reserve announced a package of $1.2trillion of Quantitative Easing in proposing to buy Government debt (Gilts or Treasuries) and mortgage backed securities over the coming months. It is effectively printing more money or creating more dollars in the economy out of nothing.

You see, the Fed does not have these dollars.

What it has is a Reserve of money or deposits and at any time it can use something known as Fractional Reserve Banking to say that at any one time not everyone will want access to that Reserve. In fact, so confident of this fact are banks, that they then create multiples of this Reserve as an amount of dollars or pounds to lend out to people. As long as they don't breach a certain ratio of circulated dollars to the Reserve then they can issue as many as they want. And this is what the Fed has done, as has the Bank of England.

Like my pyramid of champagne glasses analogy, the new money created cascades from the banks that hold the debts the Fed is buying, down to businesses and then onto consumers - and the one thing they then bet on is that like idiots we will spend this new money. We will receive it via greater lines of credit and lending from businesses and banks in the form of loans, mortgages and credit cards in the main.

Problem solved.

Not Quite

Of course, if you create more money, effectively you are reducing the value of money already in circulation and that is why the dollar took a sharp pasting from a range of foreign currencies in response to this. But it also has the effect of decreasing the yields on gilts (National Debt if you like) and again the US markets saw the sharpest ever drop on gilts yields in response. This has a big knock on effect for all people who are saving and wanting to retire as pension funds and annuities are very dependent on gilts - their value and their yields. As the Gilts market decreases, there is a large shortfall in pension funds created and in end salary pensions, the deficits sharply increase.

Quantitative Easing, just like increased long term Government borrowing, has a profound effect on the future earnings of individuals - and this time not just in tax payments but in actual retirement income. It is a short term fix which has a profound effect on the future of each and everyone of us and it is why it is a method of tackling the economy which smacks of deep desperation.

Quantitative Easing For Us

It is not quite the same but effectively in the last 10 years we, as individuals, have behaved like banks. We have leveraged our own 'reserves' which could be our property asset values, and raised more money to go and spend on other assets, lifestyle changes, holidays or consumables. As the yield on our own 'sovereign debt' was low in terms of interest, borrowing against our assets was relatively cheap and despite our own household disposal income actually shrinking over the same period, we actually made ourselves a good deal richer by releasing far more money to spend. In the wider economy this created a fantastic boost to GDP and corporate profitability and as long as our asset values remained high then there was no end to the cycle of getting more money.

The problem, of course, is that unlike the Fed our reserves were not deposits but variable value assets and their value had been artificially inflated due to the very process of releasing the locked up equity in them. The more we released, the greater their value became and the more we could release. It could not possibly be sustained - and there is a simple reason for it. The complex reasons which everyone had used to suggest it could never change was that even if there was a recession or downturn and the ability of people to repay the debt was changed, this could be accommodated for as things like unemployment could be less impactful while lots of incentives and creative lending practices could be used to keep first time buyers get in the game as someone had to be at the end of every chain.

But the simple reason was that the whole system was built on greed and that made sure that it got riddled with bad practice.

Criteria for loans went out of the window, which Gordon Brown points out was the cause or sub-prime, but it was not the primary cause as it was merely a symptom. The cause was the fact that banks were trading in debts many times over to create more profit and provide an endless supply of cash to lend for the next debt. It was the very system used to create the lending that was the problem, sub-prime became just a peripherary result that showed why the system was unsustainable. Banks had used the system of debt trading to access cash way above their own reserves which fuelled their profits and more lending and this became the principle method for growth and funding their business.

Sub-prime highlighted the folly and the availability of cash dried up immediately (The Credit Crunch) as no one had any idea who owned what asset and how much it was worth. In the UK some banks had lent 125% of asset value, some had increased earnings multiple criteria to 5 or 6 times earnings and included variable bonuses in it, some had taken external guarantees from parents or relatives, some had taken shares as security, then some had lent stupidly on the corporate market, on property - the fact was that each new loan they made had a fantastic, almost unbelievable return and this is waht produced a 162% rise in property value ove rthe 10 years.

And sure enough the whole thing collapsed.

For us, as mortgage holders who had leveraged the excess equity in our homes, the bottom quite literally fell out our world. Our money making machines - our homes - started to plummet in value and in conjunction with a lack of available credit to renegotiate the loans and a recession to threaten our abilities to repay, we saw the equity we had released turn into a massive loan with no security.

Our own version of Quantitative Easing had backfired on us spectacularly.

The Future

Real Quantitative Easing is different to how individuals raise their money but the principle of creating extra cash from thin air has real parallels. There are risks associated with Quantitative Easing as it can trigger higher inflation or even hyperinflation as Argentina has seen in its not too distant past. The Bank of Japan has used it in recent times in conjunction with zero percent interest rates to try to stimulate its economy - it has had no real tangible effect as Japan remains in a relative trough which has lasted for some years. The theory says that if this is done by Central Banks as opposed to Governments just printing money then the risks are less.

Tell that to the people who save and who are wanting to retire. They are shouldering all the burden right now to compensate for the greed of a few who could not help themselves and a set of Governments and Regulators who did not have the intelligence, gumption, fortitide and appetite to stop it.

Wild Thain

It is with a heavy heart that I bring you the news that John Thain, the superb CEO who saved Merrill Lynch from going bankrupt, has sadly resigned his new position as Head of Bank of America's Global Banking arm after just 3 weeks.

A Lousy $10m Bucks!

"Goddam it," cried one of Thain's former senior staff at Merrills, Buck Paasser. "He was a good CEO. No, scrub that - he was a great CEO. The best of the best. He saved our company from bankruptcy by palming us off to Bank of America within seconds of the bank going belly up. That takes guts, acumen and sleight of hand, I tell you."

Paasser wept openly. "All he wanted was a lousy $10m bucks of bonus," he whimpered. "What has the world come to when you take over a bank for $19bn and you can't find enough spare change to give the guy who saved the company a little pocket money? Hell, the man is practically desitute - he gave everything to that company and he made what it is today."

Unexpected Losses

I pointed out that there was the minor issue of some large losses at Merrills that might have been 'played down' at the time of the buy out by Bank of America.

"What?" screamed Paasser. "Are you trying to tell me John Thain was dishonest? Get out of here. The man was practically a saint. You can't tell me that someone that has the kind of attention to detail that redecorates his office for $1.22m would cover up excessive losses - no, sir. He should not be blamed for the price of wood, paint and fine art."

"Look, yeah so we had trouble with the calculator and Excel was playing up," continued Paasser. "We couldn't seem to make the numbers work and we kept coming up with a spare minus $15.3bn which we couldn't account for last quarter. So we just rounded the numbers up. Hey, it's not our fault BoA have to go to the Fed and ask for an extra $20bn maybe if they paid the bonus we might have wondered more where that $15bn had gone. Anyways, BoA had already used up $25bn in October so what's another $20bn here and there - as if that's going to really save the bank."

Spare A Thought

I asked Paasser if he thought of John Thain asking his Board for $10m bonus in the light of $15.3bn losses last quarter was a particularly wise or good thing to do and perhaps it had some contribution to his departure.

"Are you joshing me, buddy," screamed Paasser. "Just because the whole Finance system failed a great man does not mean he should be able to go home and feed his family, buy a new car, dig a new pool or buy a small island in the Caribbean. Jeez, where is your humanity? The guy was only asking for $10m - you make him sound like he didn't care. He did - and that was the poor guy's failing. He cared a lot about how the heck he was going to get rich again, particularly now that guy Madoff has got all us Finance guys a bad name."

In the murky world of banking, John Thain was some guy. After selling Merrills to BoA just before breaking point for $19.4bn, the last quarter figures surprised everyone but him at a walloping $15.3bn loss. And he was the man who had the chin to ask for a $10m bonus from his Board for saving Merrills.

Still, I'll lay a bet he'll be back and at it again somewhere soon. Racking up losses seems to be a marque of credibility in the World of Finance.