Is U.K. Headed for an Even Worse Great Depression? (Part 1 of 3)

by: Nadeem Walayat

The purpose of this analysis is to map out the trend of the UK recession for 2009 and 2010 in terms of depth, the bottom and the potential recovery. The most recently released GDP data shows that the UK economy actually did fall off of the edge of a cliff during the fourth quarter of 2008 by contracting by a shocking 1.5% GDP. This compares against the government's recent forecast for 2% GDP contraction for the whole of 2009, which paints a picture of gross under estimation of the actual extent of economic contraction that is taking place at this time. Hence the adoption of the easy going terminology of "Quantative Easing" to hide the truth of money-printing on a scale that could bankrupt Britain. The evidence of this has been played out in the currency markets with sterling's fall to a 23 year low against the dollar, a fall of over 30% in barely 6 months.

The fourth quarter GDP crash of 1.5% is far higher than expected and explains why the government panicked, as evident by the deep interest rate cuts from 5% to 1% in just 4 months. The rate cuts are in addition to the £1 trillion banking sector bailout liabilities. The rate of contraction at 1.5% per quarter implies an annualised collapse in the UK economy of 6% which would amount to loss of national income of £72 billion, against which the government has so far committed £40 billion in the form of tax cuts, industry support and stimulus packages. However, the deviation from the trend of 2.5% growth per annum puts the gap at an additional £30 billion per annum.

The £1 trillion committed towards halting the banking sector's collapse on face value seems like a huge amount that should kick start lending, however this should be set against contraction of an estimated 30% of the UK credit market or £1.2 trillion. Distressed foreign banks pulled the plug on UK operations, on top of which we have had housing market deflation of £250 billion, and stock portfolios erasing a further £400 billion, which sets the £1 trillion of injections and liabilities against deflation of an estimated £1.85 trillion.

The recession looks set to run throughout 2009, with the consensus view that the recession will be the worst since the Great Depression of the 1930's during which time the UK economy contracted by 10%. The question now being raised is whether Britain is heading for its own Great Depression on a scale worse than that of the 1930's ?

Britain's Great Depression of the 1930's

Britain's GDP during the 1930's Great Depression fell by 10%, which on face value compares favourably against that of the United States that saw GDP contract by 30%. However, unlike the United States, Britain did NOT boom during the 1920's. On the contrary, the 1920's was a period of stagnation that started out with the Depression of 1918 to 1921 that saw GDP fall by 25%. Therefore, Britain's Great Depression in fact started in 1918 and did not end until 1937 and therefore lasted nearly 20 years. However in today's economy, Britain is coming off of a 10 year+ boom, therefore even a 10% contraction would not be on the scale of what Britain experienced during its Great Depression. However, the argument could be made that having enjoyed a boom, Britain's subsequent bust will unwind much of the gains made during the past 10 years as the United States experienced during the 1930's. Therefore, this suggests economic contraction on a greater scale than that of the 1930's, especially if protectionism takes hold - which was the nail in Britain's economic coffin during the 1930's.

British GDP Has Already Collapsed by 30%

British GDP (AMBI) at the end of 2008 is estimated at £1.275 trillion, against £1.267 trillion at the end of 2007. However, sterling has collapsed against major global currencies by 30% or more, which translates into a real terms collapse in the country's GDP of 30%, i.e. 2007 GDP of $2.7 trillion has now fallen to $1.8 trillion - a collapse in GDP of over 30%. The Government, Bank of England and FSA are failing in their primary duty, which is to preserve the purchasing power of the currency.

The Labour government has destroyed the purchasing power of the British Pound by 30% so as to save 1% or 2% on the actual officially published GDP data during 2009. That's a price of 30% for a net benefit of at most 1.5%, which will still not prevent a deep recession from occurring. Quantitative Easing, which is madness personified, was for several months supported by the mainstream press. My November article, Bankrupt Britain Trending Towards Hyper-Inflation?, illustrated how it sacrifices long-term growth for possible short-term benefit

Therefore, whatever is the conclusion of this analysis in terms of sterling GDP contraction during 2009, what readers need to remember is that the real purchasing power of Britain's currency loss of 30% means that the country's GDP has already been sacrificed in lieu of hoodwinking the electorate into believing that things are not as bad as they actually are. Meanwhile, the price of currency devaluation is in much higher future inflation, which the government is hoping will not kick in until after the 2010 election.

British Pound Crash Failing to Boost Manufacturing

The Manufacturing sector was supposed to the save the UK economy from the economic bust in the light of sterling's 30% devaluation. However, given the collapse of global trade and demand, which has put paid to this false assumption (as I pointed out over 6 months ago), sterling's fall will not benefit Britain. This is because the manufacturing base of the country has shrunk to such a small sector of the economy that it cannot hope to offset the Financial sector's depression, which once contributed more than £40 billion in profits a year to Britain's bottom line. It is now consuming tax payers' funds to the tune of several hundreds of billions into an ever expanding black hole.

To make matters worse, the crash in the oil price has hit UK North Sea oil foreign exchange earnings and therefore contributes to sterling's downtrend with an exchange rate drop of 30%+ that offsets a large part of the benefits of the fall in crude oil prices. In fact we may reach a point in the near future of rising petrol prices despite continuously depressed crude oil prices, which the analysis of December 8th (Crude Oil Forecast 2009- Time to Buy?) concluded would remain depressed for the duration of economic contraction, i.e. probably for the whole of 2009.

UK Interest Rates

The February rate cut to 1% fulfills the forecast target for 2009 (4th Dec 08 - UK Interest Rates Forecast to Crash to 1% ). The next stop would be a similar Zero Interest Rate Policy (ZIRP) as that adopted by the United States - which cut their interest rate to 0.25%.

click to enlarge

While the base interest rate stands at 1%, the 3 month libor rate is at 2.14%, and the real economic interest rate is at 3.54%. This clearly indicates that the banks are still refusing to lend, and in effect hoarding government bailout cash injections, much of which is being used to reward bonuses to culpable staff.

Financial Armageddon.... Postponed?

2 minutes and 20 seconds into the C-Span video clip below, Rep. Paul Kanjorski of Pennsylvania explains how the Federal Reserve told Congress about a "tremendous draw-down of money market accounts in the United States, to the tune of $550 billion dollars." According to Kanjorski, this electronic transfer occurred over the period of an hour and threatened a further $5 trillion to be drawn out, triggering a total collapse of the World's Financial System, which then prompted Hank Paulson's emergency $700 billion TARP bailout action.

Following September's close call with financial armageddon, the governments of the world have been busy recapitalising bankrupt banks with tax payers' monies. However, the $500 trillion derivatives monster continues to deleverage thereby implying that the risks of financial armageddon have only marginally improved on September 2008. There still exists the high potential risk of financial and economic collapse that would be accompanied by extreme currency market volatility.

Bankrupt Banks - HBOS Blows Up in LLoyds TSB's Face

The shot-gun wedding between HBOS (OTC:HBOOY) and LLoyds TSB (NYSE:LYG) last September, in the midst of the financial markets' panic following Lehman's (OTC:LEHMQ) bankruptcy, to prevent another Northern Rock nationalisation is increasingly blowing up in Lloyds TSB's face. Yet again, the reassuring words that bankers say one week turn out to be completely untrue. The Lloyds Chairman was congratulating himself barely 3 weeks ago of how the takeover would result in cost savings of £1.5 billion per year. Tuesday's announcement of a £10 billion loss by HBOS for 2008 shatters the Chairman's illusions and Lloyds TSB's balance sheet, though it will not be the bankers that pay the price but the tax payer. Already the UK Tax payer has pumped in capital injections of £18 billion into the LLoyds TSB HBOS group.

The Lloyds TSB share price crashed by nearly 50% on the news to close at just 61p, valuing the bank at just £10 billion. This is set against UK Tax payer capital injections of £18 billion, which therefore values tax payers £18 billion investment at just £4 billion, or a £480 loss suffered by every UK tax payer. As I have warned several times over the past 6 months, the government propaganda of actually making a profit on these capital injections into bankrupt banks is an illusion which is now being borne out.

Given the size of the HBOS and Lloyds TSB loan book, that £10 billion loss is just the tip of the iceberg. 2009 will turn out to be a worse year than 2008 in economic terms, as £10 billion of share holder equity cannot hope to defend against a loan book well in excess of £1 trillion. Even a further 1% loss due to bad debts would equate to more than total shareholder equity, and given the crash in UK house prices of 20% to date with a further 18% expected as per the UK housing market forecast, I cannot imagine how the bank can hope to survive in its present form.

HBOS Bankrupting Lloyds TSB

Let's get one thing straight, LLoyds TSB / HBOS is too big to be allowed to fail, therefore in this crisis there are two measures of bankruptcy without loss of banking operations. They are: a) Nationalisation, where in effect the shareholders lose all off their holdings and in effect the bank goes bankrupt as far as they are concerned, and b) Capital injections that dilute existing shareholder equity and increase tax payer exposure. In this regard, the government's current holding at 43% of the group is pretty close to the magic 50.1% majority shareholding level that to all intents and purposes means nationalisation by the backdoor. Given the £10 billion loss, it is only a matter of time before further capital is injected into Lloyds TSB / HBOS. Therefore it is highly probable that the bank will effectively become bankrupt as far as shareholders are concerned, sooner rather than later. This has occurred already with the Royal Bank of Scotland (NYSE:RBS), where the government's holding now stands at 78%, which is just a stone's throw away from full nationalisation. And as Northern Rock (OTC:NHRKF) shareholders have found out, nationalisation results in the 100% destruction of shareholder equity. I warned about this before Lehman went bust (09 Sep 2008 - BANKRUPT Banks Wiped Out by Tulip Backed Securities).

Lloyds TSB / HBOS Depositors

Many customers holding accounts across the two banks are worried that they are now unnecessarily exposed in terms of the FSCS £50k guarantee per financial institution. In this respect I have some good news. The guarantee is per licence, and as HBOS retains a separate licence to Lloyds TSB it means that savings are guaranteed at £50k per person per bank, i.e. a £100k guarantee across both banks.

LLoyds TSB / HBOS Service

The 30 million or so customers of the giant UK retail bank will experience a deterioration in the quality of service as costs are cut and the number of staff that services the client base is significantly reduced. This means less branches and less counter staff and therefore longer branch queues and greater difficulty in resolving account issues. Also, the merger of the two has yet to be processed in terms of combining operations that was purported to save £1.5 billion per year. Therefore, expectations are for much disruption in client account operations, especially where queries requiring manual intervention to be resolved.

Nationalisation - The Only Solution

The banks are bankrupt! The only things keeping them alive is tax payer moneys in the form of capital injections and loans that are now nudging above £1 trillion. The only real solution as I highlighted last November is for the systematic nationalisation of all the retail banks. This would mean each bank is MADE INSOLVENT, then the profitable assets nationalised and quickly restructured with new competent management and re-privatised with clear limits on its business plan. This would avoid trading in any Securitized debt and a ban on any money market borrowings, which are the prime reason the banks are now exposed to bankruptcy. Other controls should be placed on pay limits across the group so as to prevent the culture of bonuses that has destroyed the banks. Also, retail banks should always be limited to operating within the means of their depositor base, which is how 99.9% of the public assumed they operated.

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