Wen Jiabao, "a little bit worried" about U.S. defaulting.

China's Premier Wen Jiabao has just been speaking at a news conference. I wrote down some of his words...

"Of course we are concerned about the safety of our assets. To be honest I'm a little bit worried, and I would like to, through you, call on the United states to honor its word and stay a credible nation and ensure the safety of Chinese assets".

Obviously the Premier was nervous because he had read my earlier blog entry.

Now the reason I think it is so significant the Wen Jiabao has publicly stated that he is worried about ability of the U.S. to pay its debts is because of something called the "risk premium". Everyone knows that when banks lend to high risk (usually poor) people that stand a higher than normal risk of not paying back then what they do is to charge a higher rate of interest. The "extra" part of the interest being to cover the risk of not getting the money back. Now currently the U.S. borrows money (to finance its great debts) from abroad, by issuing bonds. The bonds are really a statement saying "Give me your $X now, and I'll pay you back $X+bonus% later". Now the bonus% has to be high enough to A) be competitive with interest available elsewhere through other investments AND B) has to be high enough to compensate potential customers for their perceived risk of not getting their money back. So of course the higher the perceived risk the higher the effective interest rate the U.S. has to pay on its borrowings.

Now look again at the table at the bottom of my earlier blog entry... Scared? You should be!

Exactly why does the bursting of an asset bubble cause a recession?

I think it is well known that after a big asset bubble bursts, there often follows a recession. But why should that be? One could argue that, the bubble bursts - a bunch of people lose some money - after a few tears, its back to work and we all continue as before. Why doesn't that happen? This is what I think...

In this earlier post I explain how the price P people are willing to pay for goods G is a function of how "painful" it is to have our monetary wealth reduced by P. Now at the peak of a bubble, there will be a lot of people who (incorrectly) think that their current monetary wealth (e.g. their cash + their perceived sale value of their assets) is very high. So, correspondingly, the perceived pain in having their wealth reduced by P is low. Therefor they will merrily pay P for that G. Or to put it another way, why bother thinking long and hard about buying that new car because I'm rich as I'm the owner of a valuable house that I can use to fund my retirement... "Heck - I barely ever need to save ever again!".... Now comes that bubble bursting - the house never was that valuable - it was all a charade - the houses were only "valuable" because people thought that their price was going to continue to rise forever - the fundamental, true, value was way lower. Now let's reconsider that price P. Again we have to consider how much "pain" is caused by the loss of wealth, P. Now its all different - the same P is looking like a far bigger fraction of your existing wealth. The size of that financial buffer between where you are now, and poverty, is going to have shrunk dramatically. Therefor the size P that you are willing to pay for G has correspondingly shrunk dramatically. Or in other words it has become more painful to depart with your money... or... you are going to try and spend less if at all possible. Now this is not much of a problem globally if it was only a relatively small group of people that were duped by the bubble. The overall reluctance to spend will be small. The real trouble comes if A) a large number of people got duped and B) the size of the bubble was large, i.e. the peak price of the asset was way bigger then the logical price. If many people got stung badly by the bubble-burst then the global reluctance to spend can trigger a self fulfilling cycle or recession (as described here). This is what is happening right now - a huge number of people in many countries were tied up in this bubble, so there is correspondingly, a widespread reluctance to spend... and through self fulfilling feedback, the "widespread" reluctance has grown to an almost universal reluctance.

Give us free trade!

George Bush, and capitalists everywhere... say "we want free trade - remove the barriers!"
They chant it like a mantra.

Give us free trade... remove the barriers!
Give us free trade... remove the barriers!
Give us free trade... remove the barriers!
Give us free trade... remove the barriers!
Give us free trade... remove the barriers!

OK... lets give them what they want (in several steps) and see how they like it.

Lets say we are God and we can arrange all the following things...

Step 1. all china's legal barriers to trade are removed.

Happier now?

Step 2. all the U.S. trade barriers are correspondingly removed.

Happier now?

Step 3. God re-arranges the continents and slides China over the earths surface so that its touching America.

Happier now?

Step 4. God rearranges the shapes of both countries like two interlocking combs so that all parts of America are within easy commuting or transportation distance from China.

Happier now?

Step 5. Legal barriers are lowered so that workers from each country can cross the borders in to the other and work in each others factories.

That's just about the freest trade you can get.

They must be ecstatic!

Now tell me what's going to happen to your average wages compared to the Chinese?

....still ecstatic?

How NOT to think of a trillion.

I've seen a lot of people jumping up and down about how big some of these numbers are in this crisis. I've seen people say that if you stacked up the bills they'd reach the moon or circle the globe and all that. See here for an example. But actually this irritates me because it serves no purpose in making the numbers more understandable. The thing is that there are already some massive numbers that could be reported from an economy that are not indicative of anything abnormal. I dare say that the number of cups of coffee drunk by Americans each year is a massive number that most people would not be able to visualize very well. So what should we do when faced with these "massive" numbers. Well a better thing to do is divide them by the number of people in the country to get perhaps the debt per person. But I think its possible to do one step better than that. What we should really do is divide by the number of workers in a country. After all, retired people aren't going to be paying back any of this debt. And neither are children. Now you may say "aha, but children will grow up to be workers, so the debt will fall on them"... this is true, but as children become workers, workers become retired people (approximately). So the burden of debt is always on the workers.

So lets do the math for American government debt. I'm guessing that about half the population are workers at any one time. Assuming 11 trillion debt and 300 million population (=150 million workers) then the debt per worker is 11,000,000,000,000/150,000,000 = $73,333.

Now lets have a look at how much would need to be paid in interest alone on $73,333.... of course the interest rates could change at any time, so I'll make a table...

So, if the interest rate on the money is the figure on the left then each worker in the U.S. will be paying the figure on the right just to pay the interest.... that's before even paying pack one cent of the actual debt itself. And of course this is totally separate from the tax you have to pay the government for its "ordinary" expenditure.

So to start properly paying this money back - the government will have to raise enough taxes to pay for all their (non-debt related) expenditure. Then add the figure on the right. Then add another chunk to start reducing the debt (how about $2000 per year?).... Is Obama brave enough to do that?... or will the U.S. just decide to default? It's got to be one or the other eventually.

A great article

I just came across an article that gives such a clear overview of the current crisis that I'm just going to put a link here and encourage people to read it: More debt wont rescue the great American ponzi. Oh, and for anyone who doesn't know the word "Ponzi" yet, take a look at the Wikipedia entry here.

A blog "un-entry"

Just a note to say that I deleted my blog entry "List of countries by current account balance?" because someone posted a reply which revealed my ignorance on a certain matter. And presumably nobody wants to read about stuff that's clearly wrong (or do they?). Anyway, having my misconceptions corrected is half of what this blog is for - so I'm happy.

100% mortgages? Not a problem!

Over and over again I hear people claiming that a big part of the current crisis was that banks were giving people 100% mortgages... but I think they are missing the point. I think it should have been no problem at all to have given people 120% mortgages - if their income was high and the house was cheap. The vastly more important thing to measure is the income multiplier! Having a high income multiplier is dangerous because that's what really tells you the chances of default in the long term. Having a high income multiplier for your mortgage is like living on the edge of a cliff - the slightest rise in interest rates and suddenly you're in trouble.

Now had people all been talking about income multipliers instead of the erroneous "100% mortgages", then they may have noticed that in the long term the income multiplier has historically been around 3 to 3.5. And it only rises above that in bubbles.

According to the Halifax, the typical income multiplier for houses sold recently in the UK is 4.42, so if anyone asks me how much more the UK house prices will go down, I would say down in the ratio 4.42 to 3.25-ish... so that's about 25% more to go from where it is today.

Finally - I just had a quick look at the Halifax historical data and saw that the multiplier reached 5.84 in July 2007. How on earth did any economist or banker not know that this was a massive speculative bubble?

Below is a chart showing what percentage of your income would be required just to pay the interest on your loan, given a 5.84 income multiplier, should the mortgage rates become the values in the left hand column.