Standard & Poor's revise US debt outlook to 'negative'

It's not even been a week since gold broke the £900 barrier here in the UK and today sees it making new highs at £921 an ounce whilst the Dow Jones tumbled 222 points.  This comes as Standard & Poor's announced today that they are downgrading their outlook on the US's long term debt from stable to 'negative' due to the scale and indecision surrounding the nations problem.  The US retained its 'AAA' ranking, but this does raise more concerns over the nations debt problem.

"We believe there is a material risk that US policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013."  "If an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the US fiscal profile meaningfully weaker than that of peer 'AAA' sovereigns."

Fortunately the Republicans (some of them at least) are starting to get the ball rolling, scalping Obama for a few cuts in exchange for averting a Government shut-down the other week.  A 2013 deadline also gives them time for another presidential election, where no doubt the issue of sovereign debt will be a hotly contested issue.  If however the US was to loose its triple A rating it would substantially increase its costs of borrowing from foreign investors, putting even more pressure on the nations already struggling finances and currency.  This is a pretty bad start to the decade for the worlds reserve currency & biggest economy.

Marginal Producivity of Debt

 The other day I came across a very interesting tool and way of looking at an economy, the ability to measure the GDP generated yearly against the level of debt taken on by the nation.  In other words how has every £ added in debt helped the economy grow?

Unfortunately I could only find this statistic for the USA so I've comprised my own charts for the United Kingdoms public & private debt levels using various public resources (including the 2011 budget).

The first chart belows shows how public level of debt reflect changes in the UKs GDP since 1988, this information was collected courtesy of UKPublicSpending and the 2011 Budget.  The total deficit line (blue) comprises of the economies total borrowings for each year (public and private liabilities) vs changes in GDP and the total public debt line (red) demonstrates the total net government debt vs changes in GDP.

Clearly in the 2008/9 recession there was a negative change in GDP therefore every £ spent results in a negative return, this is not to say that the spending was the cause of the recession (although there is probably some truth in that) just an analysis of the return for every £ added in debt.  Interestingly both of the data lines show downward trends towards 0 (where adding debt is no longer adding towards GDP growth), with total yearly debt reaching the line before total government debt.  In fact the economies total liabilities, including private debt (mortgages, business loans, etc), has shown a much more consistently downward momentum than total government debt.

This diminishing return on borrowing may be down to a number of factors; the increased availability of cheap loans diverting resources to less productive areas of the economy, loss of purchasing power in the £ (currency devaluation/inflation) or perhaps even market saturation with credit.  If the total yearly economic deficit line is to be believed this year we will find that more borrowing (in both public and private sectors) is actually going to start negatively affect the economy (another recession), however the BoEs low interest rates continue to encourage borrowing over saving.

 

This above chart shows the change in GDP compared to total public debt since 1921 with  a 15 year moving average and the % change in debt levels (deficits & surplus).  Interestingly not since the Great Depression and WW2 have we seen the GDP Change/Debt ratio dip below the 0 mark and never before has it coincided with such a huge leap in government debt.  Even in the recessions of the 80s and 90s (where you can see a nice bubble), despite large declines in the return on borrowing, we never fell close to the 0 return mark.  However in 2008 as borrowing doesn't seem to have had such a positive effect stimulating GDP as it had in previous years the recession pushed us below the 0 return line and into negative GDP for the first time since 1945.

So what does all this tell us?  From the looks of things we are moving into quite uncharted territory, we have worked up a substantial debt over the past 40 years (constant percentage increases in debt) and our trend lines suggest that the ability to borrow and stimulate growth has been and continues to diminish.  It's quite difficult to predict exactly what this all means, the next few years will show us whether 2008 was a blip or the start of a new trend; where borrowing in either the public or private sector struggles to produce sizeable levels of growth.  When you combine this with the wider picture; currency devaluation, trade deficits, food shortages and the other stuff BoE economists have been "holding at bay" for years, it certainly looks like we are in for a rough ride.

Security in an Anarchistic Society

Being an open Anarco-Capitalist in discussions I often attract very similar remarks when talking about the issue of security & the police.

"Oh my god you moron, don't you realise that without police crack heads will rob your house and kill your family."

The above is a fairly typical response to the idea that we don't need state provided police, my response is that I have never actually witnesses police offers stopping a crime in progress.  Most criminals are smart enough to take a quick look around before smashing in a window.
 
I have however witnessed many police offers harassing teenagers, punishing those who don't wish to purchase car insurance & cracking the skulls of those who's opinions differ from that of the state.  Meanwhile store security staff detain shoplifters, private security personal protect corporate & private property & ordinary citizens tackle armed robbers.  This is not to say that the police don't perform an important function, just a function that can be performed equally well, if not better, by private citizens.

Coming back to the earlier satirical response, the notion that crime rates will increase in the absence of state police is nonsense.  "Crack heads" are still quite capable of robbing and killing you if they want even if you throw an extra 100 community support officers onto the streets.  The police simply cannot be everywhere at once and unless one happens to be swandering down your street whilst your house is being robbed there is little chance that a squad car will arrive before your TV has found its way into someone elses living room.  But even so everybodies house is not being robbed.

I think this issue really boils down to a failure to understand what deters people from committing crimes.  I can identify two factors; firstly and most obviously peoples sense of moral decency.  Most people find the thought of killing somebody terrible not just because it is against the law, but because they feel bad about ending another persons life.  The same moral conscience applies to most crimes; theft, rape, etc.

Secondly, for those who's moral conscience is either non existent or temporarily impaired, the prospect of being caught and suffering punishment is the only other deterrent.  If someone misses both of the above criteria then they would have no issue with harming another individual; hence why no matter how many laws or police you have some people will always commit crimes.  However do either of these factors evaporate if state police were to disappear?

No; moral conscience is not maintained by the state, it is instilled in each individual through upbringing and social standards.  Does the deterrent to commit crimes suddenly disintegrate in the absense of the state? I agree that with an absolute abolishment of security there would be no punishment & therefore every reason to commit a crime, beside your own sense of decency.  However that sort of scenario is absurd, people could and would provide their own security & punishments through the use of local private security/police forces or self-defense.

Local neighbourhoods could pitch in for a "bobby" or two "on the beat", bigger security firms could provide larger areas of call-out coverage to protect people form crimes in progress, private-investigators or bounty hunters could be used to tracking down criminals.  All of this can be provided with several added benefits over state provided policing.  Those who would rather take the risk and defend themselves can save their money, local areas can bluster up security if they wish without having to wait for a state prescription & there would be no absolute position of power to persecute the populace as competitive firms would keep each other in check (e.g. CompanyA is behaving in a way I don't approve of, I'll take my business to CompanyB).

Does anyone honestly believe that community support officers are a necessity to prevent the country from breaking out into a crime spree?

Gold, a Quick Review

With more global turmoil & financial pressure since I first took a look at buying gold let us take a quick look at how our investment has done.  The spot gold price was £854 on the 18th February and today is reaching new highs of just over £900.

 

Now granted, there are purchasing costs involved but with the cheapest I found, 3.5%, an investment in gold at £854 would already be yielding roughly a 2% return so far this year.  To put this in perspective banks are offering a typical interest rate of 3% - 3.25% for a tax free ISA, gold has outperformed the banks yearly rate in under two months.  Whilst a small gold investor may have only recently covered their purchasing costs there are still another 10 months to go in the year, just how high can gold go?

Originally we were not really looking at making much of a real term profit with gold, only protecting ourselves from inflation and fiat currency devaluation, but there are whisperings which suggest that gold could shoot much higher (not anytime soon though).  There is very little doubt that the bull market in precious metals will continue so long as the Western world devalues its currencies, takes on more debt and tries to print/stimulate their way out of this mess (which could easily last several more years).  But we must also consider the current real lack of demand for precious metals amongst the general populace, even many investors are still mainly steering clear of gold in favour of the propped up stock market.  When the fiat currency problems really get under way, inflation goes through the roof and savers (the few who are left) can't get a good enough return from the banks, you would expect to see a much larger leap into gold, thus increasing the price much faster.

Once/if this happens we must begin to beware of a bubble, with over eager investors leaping into gold assuming that it is a guaranteed money maker (see the housing or .com bubbles) the real fun begins and we can ride the bubble as high as and as riskily as you like before selling and taking a nice profit, leaving the suckers with an overvalued commodity.  The real problem here however is that the currency issues probably won't be over at this point, so it would be worthwhile moving your profits into a different investment, perhaps other commodities or related stocks.  This scenario may seem a little fanciful to some and its certainly a little way off, but we are starting to see the results of inflation rear its ugly head, the Euro zone continues to struggle with debt it simply can't repay and the US still has the printing presses on full blast.  Seems to me that this is a good enough reason to stay in precious metals, but just beware of the public at large eventually catching wind and blowing up the bull (if the BBC starts talking about gold investment then it's probably a good time to start looking for a way out).

Just a little mention, take a look at silvers recent performance.  Before leaping on this wagon beware of a potential correction and read up on it first.  As before a little disclaimer, investments are risky; just because gold has had a good year so far doesn't mean that it will continue to do so.    Personally I'm in gold for the long game as I believe in an eventual explosion of currency problems and I don't want my money to be a part of it.  Predicting the market is virtually impossible we can only make educated guesses and this is something for you to make up your own mind on.

Dispelling Cost-Push "Inflation"

I think we need to set this straight, my favourite of all public services, the BBC, has published an article on the Bank of Englands decision to keep interest rates at only 0.5%.  They goes on to discuss inflation and supposedly how the BoEs interest rates affects it.  However they seem to have confused themselves and are giving the public the wrong end of the stick.

Inflation, in the true economic sense of the word, is an increase in the money supply.  This is sometimes referred to as Monetary Inflation to distinguish it from what I suppose the BBC is getting at: Price Inflation.

With the nations most popular broadcaster spouting claims like "Inflation continues to be boosted by rising commodities prices" it is no wonder that Mervyn King can still scalp the British public for his utterly useless services.  In order to debunk this myth please follow me through a couple of simple examples, using only the economics 101 supply & demand graph as our aide (for those unfamiliar with this law of economics have a quick look here).

The confusion with inflation comes from assuming that price increases are the cause of inflation, but this is a fallacy; higher prices are a result of inflation.  Let us first consider a scenario based around this mistake, where a company (or several) put their prices up whilst the money supply is kept constant.  Our supply & demand chart shows us what happens when a company increases its prices, either we can move towards equilibrium (the point where supply & demand are balanced) or away from it.

For the first scenario we must remember that a company cannot increase prices to infinity as demand will keep on decreasing, they must strike a balance between price and demand which results in a sustainable profit.  The same rule applies equally for when a price increase moves towards equilibrium, it is only viable so far as income remains fixed or increases.  So if we assume that company A increases prices, then a higher proportion of the total money supply (which is fixed) will be spend on product A, which means that other companies will witness falling demand (less money available to be spent on their goods).

Contrary to the popular belief in spiralling wage hikes to keep up with increased costs of goods, company B will find that it can no longer afford to pay its employees such high wages (as the money supply is fixed where could they magic up the extra cash?).  Therefore higher prices in company A may also see it witness further falling demand.  In order for any price increase to be sustainable it can only go up providing other sectors of the economy can still afford to buy its goods whilst witnessing falling demand for their own product.  The fixed money supply means that a balance will naturally occur, where one sector increases only to a sustainable amount at the expense of other sectors in the economy.

The often proposed "inflationary spiral" where prices increase, so workers demand higher wages, so price increase, to infinitum simply cannot occur without an increase in the money supply.  Where does the extra money come from to increase the price in all goods or the salaries of the workers to purchase these goods?  Can you have more than 100% money supply?  This is a zero sum game, although prices have changed there has been no overall increase in the cost of money, a.k.a no inflation.  So where does inflation actually come from?

There are two possible causes: firstly we haven't accommodated for growth or recession, which we can easily identify as the economies output vs money supply.  In the case of growth we are producing more goods, therefore if the money supply is kept constant then we will witness deflation in the value of the currency.  The chart below may go some way to help picture this:

Consider 1x multiplayer as your economies current state, as it grows the multiplier increases and goods seem cheaper (purchasing power increases) and in recession your economy contracts (decimal multiplier is a shrinking economy) and goods seem to cost more (decreased purchasing power).  Note how as your economy doubles goods cost half as much, or when it shrinks by half (0.5 multiplier) goods cost twice as much.   (Any mathematicians may have noticed this would form a perfect asymptote, y=1/x.)

To best understand this form of inflation is to consider currency as a good just like any other, in recession the number of other goods is declining (increasing demand) whilst the supply of currency remains constant.  Therefore consulting our supply & demand chart will show us that prices will increase in recession & decrease in growth.

The only variable we have haven't altered yet is the actual money supply, this is delt with very simply by our favourite chart.  Demand for money stays the same, although I could argue that it actually falls, but as supply increases the equilibrium has shifted lower.

This reduction in the value of money reduces the purchasing power of all goods due to comparative value (e.g a car represents more labour and materials than a paper clip even without currency).  This could also been seen as an increase in the demand for currency (as you require more of it to buy the same item) on the above charts for growth and recession.  If you increase the supply of one good vs another then the one of limited supply will be traded for more of the readily available good, which we view as increasing prices.  This is true inflation as prices have increased for all goods in the economy compared to the currency, even though they maintain value compared to one another.

So there you have it, true inflation can only be caused by one of two things: excess money supply or recession (only where the number of goods actually shrinks).  Increasing prices are a result of inflation not a cause; perhaps I'll send this essay to the BBC.