Deliver Us From Swedish Furniture

UK folk earn more than their US counterparts

A friend of mine sent me this from the Beeb and for the first time since the turn of the 20th Century, people in the UK will be earning more per person than their US counterparts. Partially down to currency fluctuations, but also down to the higher economic growth, which unsuprisingly are related - if your country gets stronger economically then so will your currency assuming you don’t print too much of it. Now I have never been a fan of Bush, from the start I thought he was a hawkish half-wit with a bunch of oil hungry cronies in tow…or rather paying his way. Now I could go on about how he managed to turn the huge amount of goodwill the rest of the world felt towards the US after 9/11 into a state of affairs whereby being an American abroad is bad for your health. So after spending trillions on his ‘war on oil’…sorry ‘terror’ which seems to have done a good job of increasing terrorist activity by acting as the best recruitment advertisement Al-Qaeda could ever have hoped for (and just the response the provocation of 9/11 was supposed to induce) He has also introduced some restrictive trading practices that have seen the WTO (not normally known for their anti-US bias) hand out several penalties against the US. Lastly, and probably the most harmful, is the floodgates were opened on cheap credit leading tohuge inflationary pressures on prices, which meant that globally the dollar had to fall - how does this affect anything for the average joe? I’m glad you asked, because that means I can go off on one of my periodic, but always dull economic lectures….

This low interest rate climate in the US (compared to the rest of the world) meant that credit was available for all manner of investments. So, imagine that you can get 10% for no risk by putting your money in the bank. This means that for a ’safe’ investment (ie one you consider has low risk, but some chance of losing you money) then you may feel OK to accept a 20% return in these circumstances. For higher risk you may need to look at a potential 40% return to be worth putting your money into. Now let us assume that the Fed cuts rates and the banks now only offer 5%, so for the same level of risk as before, you now only need to return 10% to make it a worthwhile investment and only 20% for the risky investment (if you consider the risk as doubling between the safe and risky investment, then you only double the return required to make it worthwhile) So all the time that the rates are kept low, then people will be tempted to borrow money at these low rates to put into investments as if you can borrow at 5% and invest at a 20% return it must be good, right? Lets say you put $1000 into ten of these investments at 20% and one fails totally, then you get 9000*1.2=$10800 or an 8% return, so that is OK? Well it is fine if you are correct in your assessment of the risk, you are only getting in reality 3% more than in the bank. Now imagine that instead of one, two of your investments fail. All of a sudden you have now got a return of 8000*1.2=$9600 or -4%! However this -4% is in actual fact -9% as you still owe the bank at the 5% rate. We can also see what happens as the interest rates rise, if it goes to 6% your return with one failure is only 2% and your loss is -10%. So in reality, these are not good investments as their actual risk to reward ratio is obscurred by the low rates.

Now since more money is being called on to invest, in these seemingly good investments, the money supply increases as there will always be more lower rate risky investments then higher rate risky investments as firstly there are always more mediocrity than excellence and also the good investments will simply charge more - you can always charge more for excellence after all. This has the effect of devaluing the currency - think about it, if the economy grows by a smaller amount than the money supply (relative to other currencies!) then it must devalue. Now if inflation kicks in, the rates must rise to compensate as this means that you must get a better rate of return to borrow money to invest in it or spend it (remember an investment is anything you spend money on as you are investing in your happiness if you buy yourself new toys….or something like that!) so people buy/invest less, which puts less demand on the markets, which means that inflation will decrease, but it will also mean that the things that were giving a risky 20% (which is in fact only an 8% return as we saw above) are now devalued as who wants this when they can get a safe 10% in the bank? Now imagine that those people who have bought these risky 20% investments have done it with borrowed money and this borrowed money is now more expensive, so they cannot afford to pay it all back. They have two options, they can default or they can sell some of their assets to pay back some of their money, but these assets are worth less than before, so they cannot pay back all their money. Since they cannot pay back their creditors, their creditors also have less money to put into the pool, further decreasing the money supply…. The boom/bust seen in the mortgage market is simply this playing out. Had the US held their base-rates at a sensible amount, the bubble would not have formed as prices and expectations would not have deformed as we saw. It may have made people a lot of money during the boom, but due to the leverage (the borrowed money) there is always far more to lose than was ever made. The UK and Europe have been far more circumspect with their economic policies and the Japanese, after years of deflation have seen their currency and interest rates rise too, leaving the US in a very unfortunate position - the Japanese and Chinese have been buying US bonds for years. US Treasury bonds are essentially IOUs. The Chinese have been buying these to allow the US to continue to buy their stuff, the Japanese have been buying them because they could get Yen at very low (try 0%!) rates, buy US bonds and, even at their low rates of return, make money pretty much risk free. However as soon as Euros, Sterling etc started to offer better rates for similarly low risk the money started going there instead and, as the interest rates rise, the value of the lower rate bonds has to decrease to match the valuation of the new, higher rate bonds. All of this means a lower demand for US debt and since US debt is currently at it’s highest level ever and demand is dropping for the reasons above, it’s not a good thing for the US economy as it will struggle to maintain it’s debt load. As the US bonds are retired (they have a lifespan) the new ones have to be issued at a higher rate to be attractive to investors and support the current debt load. The only way they can do this is to up the rates, which affects the money supply. So the dropping rates you see in the US can only be short term as they have no way of retiring the debt quickly.  The last part of the sorry tale to clobber the beleagered US economy is the rising prices globally of commodities. Since demand from India and China is increasing for copper, gold etc and the supply cannot increase as fast (it takes years to open new mines) then if the basic materials are increasing, then inflation must increase as inflation is, after all, simply a reflection of the annual rise in prices. That is yet more inflationary pressure for an economy that is currently trying to reduce rates to increase money so it’s financial institutions can get enough money to simply service their current liabilities….it’s not very pretty is it.