- Overall sectoral flows are now negative and getting worse thanks to a current account deficit and government austerity politics.
- Private credit creation from banks is driving money growth but households and businesses cannot deficit spend by borrowing money from banks or spend accumulated savings to fund expenditure indefinitely.
- The current account deficit is draining growth.
- The net money supply is decreasing domestically and deflation and unemployment must result.
The purpose of this report is to look at macro money flows in Great Britain and assess the impact on investment markets.
I last looked at Britain in the following articles:
This report was produced using a balance of national accounts assessment of Great Britain.
One can summarize the national accounts in the following formula:
GDP = Private Sector Spending [P] + Government Sector Spending [G] + External Sector Spending [X]
See the methodology section below for more detail on this formula.
Each sector will be examined in turn starting with the private sector.
The private sector is where the stock market is and we as investors want the stock market to go up. The stock market can only go up if the flows into it are positive. The private sector derives income from three sources:
Credit creation from banks - More loans created than repaid. Also known as credit money bank money, endogenous money and inside money.
Externally from overseas commerce - More exported than imported.
Government spending - more spent than taxed out. Also known as sovereign money, state money, outside money, exogenous money and high powered money. It has no liability attached to it.
In an ideal scenario, the private sector would receive large, and growing income flows from all three sources, and at the very least, the overall impact should be a positive flow overall even if one or two of the three flows are negative. The stock market in the private sector, as well as all other private financial assets, should rise if the overall income flow into the private sector is positive.
The table below shows the level of private credit creation entering the private sector through commercial banks in 2017.
In 2016, private banks put about $98 billion new GBP into circulation or about 3.7% of GDP.
In 2017, they put about $82 billion new GBP into circulation or about 3.1% of GDP.
In 2018, one could expect a similar performance.
The chart above shows the M3 money supply and shows that over 2017 it has grown by 180B GBP or $249B.
The flow of private credit adds to the stock of private debt in the economy, and this stock is shown in the chart below.
The stock of debt is 165% of GDP. The impact of the debt service on this stock of debt can be modeled over a range of interest rates as shown in the table below.
The central bank rate is 0.5%. Commercial lending rates for a mortgage, the most substantial credit component, is about four percent. The debt service income flowing to banks is about $174B or 6.5% of GDP. This is income that could have been spent on real goods and services in the real economy. Despite this relatively high rate credit growth continues.
Professor Steve Keen has found that a private debt level of 150% of GDP tends to be a natural barrier and that economies that reach this level tend not to become more indebted. Great Britain has exceeded this natural level and appears to be growing through it.
The debt load moves inversely to interest rates and if they halve debt can double. If rates rise in Britain, there is going to be a real problem servicing private debt. Every one percent rise is an extra $43B that flows to the banking sector from other sectors of the economy or 1.69% of GDP.
The most likely outlet for rising debt levels is a rising land price given that most lending is mortgage lending and accommodation is a basic need one cannot do without. Better would be lending for productive capacity and house price control via lending based on rent income rather than the capital value of the land.
This would end stretched yield to house valuations and also stretched mortgagees.
The external sector captures trade and commerce with other countries and is shown in the current account. The current account is exports less imports, and also includes capital flows in and out of the country from financial transactions and investments. A positive overall result is best.
Britain runs a current account deficit, which means that it exports GBP in return for imports of goods and services from overseas. This is shown in the chart below.
In 2016, Britain exported $117 billion of GBP in return for foreign goods and services. This added to the stock of GBP held by other nations.
In 2017, the country exported $128 billion of GBP, further adding to the stock held by foreigners.
2018 is most likely to be the same and see a net export of GBP. If this followed its linear mathematical conclusion - which it will not, as it is cyclical - all GBP would be exported overseas, and none would be left in Britain!
This current account balance flows to the stock of foreign reserves held. The stock of foreign exchange reserves is shown in the chart below.
Reserves rose $22B in 2017. One might ask how is this possible with a current account deficit that should have reduced foreign currency reserves?
Britain does not have a deficit with every land that it trades with, only most of them. While denominated in $US as a total above, in reality, there is an account for each different currency the government holds as a reserve following currency conversion. Also, the government may have bought foreign reserves to "manage" the valuation of the GBP.
The government budget is in the chart below.
In 2016, the government added about $79 billion worth of new GBP to the economy by spending more than it taxed.
In 2017, it removed -$1 billion worth of GBP by taxing more than it spent. This GBP no longer exists - and reduces the stock of GBP by that exact amount. From $79 billion to -$1 billion is a big drop. The Government's "surplus" does not appear on any measure of money stock not M1, M2, or M3, it simply vanishes.
2018 will probably see a similar result as for 2017, with a net reduction of GBP as the government taxes them out of existence.
The British government is a monetary currency sovereign, the legal issuer of the GBP. The currency sovereign has a relationship with its unit of account similar to a football referee and the points he awards on the scoreboard of a game when a team scores a goal. Money is keyboarded into existence when the government pays for real goods and services from the private sector and is deleted again when it receives tax payments.
The government is required by law to issue a government bond to MATCH its deficit spending. Note I write MATCH as the money for the bond is already in the economy and moves into the bond for the term of its maturity. This is a low yield risk-free investment. A term deposit with the issuer of the currency who can always pay. The government spending still comes in addition to this existing bond money and the bond does not fund the spending, net assets in the private sector rise overall from the government deficit spending. Bond "debt" issuance is a procedure left over from the days of the gold standard and still goes on.
The stock of government bonds and the impact of interest payments across a range of interest rates is shown in the chart below.
Government bonds cause a misallocation of resources for the following reasons:
1. This money could have gone into a more worthwhile productive investment instead of a low yielding paper asset.
2. The government bond auction system can cause the interest rate for bank lending to move when it might otherwise not have.
3. The primeval fear of debt can cause governments not to spend for fear of accumulating debt to grandchildren or foreigners when the bond issuance is an unnecessary tradition from a bygone age that now blocks government spending on the public purpose in the modern age. The primeval fear is driving the austerity mantra currently in vogue in the UK. This commonly misunderstood fact is doing the most damage to society than any other factor. But for this mental block resources could be deployed to solve most of our societal problems such as poverty, healthcare, education and environmental protection.
4. Government bonds held by foreigners cause leakage of interest income out of the domestic economy.
5. The resource use employed to create, issue and monitor the bonds, buildings, energy, and people that could be doing something useful instead.
The only good things about government bonds are:
1. They provide a risk-free bank account for private sector savers.
2. They cause the government to spend state money into the economy and give the private sector a debt-free income channel and overcomes to some extent the damage done in point 3 above.
At present, the British 10yr government bond rate is 1.46% meaning that it is paying some $35B in interest income to the private sector or 1.34% of GDP. This adds to growth and forces a recalcitrant national government to spend. The actual amount of the spend varies as bond yields are laddered over time.
Sectoral Analysis Methodology
Cambridge Professor Wynne Godley developed the stock-flow consistent sectoral balance framework of analysis.
Each nation state is composed of three essential components:
The private sector
The government sector
The external sector
The private sector comprises the people, business, and community, and most importantly for investors, the stock market. For the stock market to move upwards, this sector needs to be growing. This sector by itself is an engine for growth and innovation; however, it needs income from one or both of the other two sectors to grow.
The government through its Treasury sets the prevailing interest rate and provides the medium of exchange. Too much is inflationary and too little is deflationary. It puts the oil in the economic engine and can put in as much as its target inflation rate allows. It is not financially constrained. For a sovereign government with a freely floating exchange rate, any financial constraint such matching bond issuance with deficits is a self-imposed restriction. A debt ceiling is also a self-imposed restriction as is a fiscal brake.
The external sector is trade and commerce with other countries. This sector can provide income from a positive trade balance, or it can drain funds from a negative trade balance.
For the stock market in the private sector to prosper and keep moving upwards, income is required to be put into the flow. Otherwise, the sector can only circulate existing funds or is being drained of funds and is in decline.
The ideal situation is that the private sector has a net inflow of funds and is always growing, thus giving the stock market headroom within which to expand in value. For this to happen, one or both of the other sectors have to be adding funds to the circular flow of income.
The following formula can express this relationship:
GDP = Private Sector + Government Sector + External Sector
These are accounting entities and correct by definition.
For the best investing outcome, one looks for countries with stock markets located in private sectors that are receiving positive income flows overall. Top marks come where private credit creation, the government sector, and external sector are both in plus and trending upwards.
Conclusion, Recommendation, And Summary
When we take our inputs and place them in our formula, we can calculate the following sectoral flow result based as a percentage of GDP.
The Sectoral Balances are set out in the table below
External Sector Balance
Government Sector Balance
Private Sector Balance
(Source: Trading Economics and Author calculations based on same)
#Forecast based on present trends and plans.
Total money creation is set out in the table below.
From the table above one can see that the private domestic sector is being steadily drained of income and the stock of money in the sector is in decline.
Even in 2016 when the government was injecting 3% of GDP into the economy, the current account surplus was still draining out more that was being created, which put the private sector into deficit.
What this private sector deficit means is that savings are being run down and loans were taken out to maintain consumption. At some stage, this will be exhausted and recession results. Minus six is a big drain. The highest in the developed world. The UK is ripe for a recession and one does wonder if the economy is being weakened deliberately to cause a recession that can be blamed on Brexit and used as an excuse to undo the Brexit decision.
Private Sector Money Creation
Government Sector Money Creation
New Money Exported
New Money in Private Sector [P]
(Source: Trading Economics and Author calculations based on same)
*Estimate until actual figures are reported.
#Forecast based on present trends and plans.
The table above shows the same sectoral balances but expressed regarding money creation. The table shows that the private sector deficit identified in the sectoral balances table was paid for with private credit creation. Households and businesses went into deficit to fund imports.
Over time this picture has gotten worse in that the current account deficit has grown larger, the government has destroyed money with a budget surplus, and the private sector has funded the export of GBP to fund import purchases through credit creation and also by running down its stock of savings. This is not sustainable.
The column on the far right shows the money supply in mainland Britain declining, which should result in deflation and unemployment. The column second from right shows the stock of GBP held by foreigners increasing. The third column from the right shows the overall money supply in decreasing supply, which is deflationary overall and a relative scarcity of GBP could send it higher.
One can see from the tables above that the private sector flow rate is negative in 2017 and will most likely get worse in 2018. This is mainly due to the current account deficit, but a new addition is the government surplus, which is deleting GBP out of the economy and reducing the overall supply of GBP. This will push the economy into recession and paradoxically send the GBP upwards in value as its supply diminishes.
From the table, we can see that each year less GBP are created, and also that more are exported to the external sector than created.
This means that domestic private households and businesses are:
- Going into deficit by borrowing money from banks to fund expenditure, or
- Spending accumulated savings to fund expenditure.
Domestically less GBP are created and of those that are, are being exported overseas to pay for imports.
Under the above conditions, GBP must rise, and internal deflation must occur due to the reduction in the stock of domestic GBP. When a domestic economy has a net reduction in money unemployment of land labor and capital is normally the result.
I go into far more detail on forex implications for the GBP in this article.
The British private household and business sector cannot deficit-spend and run down savings forever, and at some stage, no more credit will be sought from banks or granted by banks and savings will be used up. Before that happens, a recession will occur, and the government will be forced to deficit spend on unemployment benefits. The government will be forced to use its powers of sovereign currency creation to issue more GBP to meet its expenditure on a recession that it created with its austerity policies.
Another alternative is the government could borrow from the stock of GBP held overseas as it did in 1976. This was the ridiculous situation where overseas banks, via the IMF, hoodwinked the currency issuer into borrowing its own money that it could have created for free. Today's politicians will fall for this trick again.
So now we look at investment markets and the likely way forward.
Something in the Great Britain business and household budget is consuming a lot of earned income and causing them to go into debt. The most likely culprit is accommodation. The chart below shows the house price index.
Housing [land] price has risen incredibly since the 1980s. Even the GFC peak reached in 2007 has now been exceeded.
The chart above shows construction activity. The chart shows that it has now gone negative. Given that most credit creation is for housing it is likely that credit creation will soon slump with construction activity. The supply of housing will restrict, and prices will rise, given the population is growing.
The price rise will be blamed on a lack of supply whereas the real story is demand side and a lack of borrowers willing to take on a mortgage in a recessionary economy, the deletion of currency by the government is making its presence felt. Builders stop building for a reason, and it is normally a lack of buyers. If you build it, they do not come if they do not have enough money.
The chart below shows that on average a house costs five times average earnings. Five times earnings seem to be a natural barrier reached in the 2007 GFC and reached again now. Even London with its international clientele of mostly cash buyers has hit a barrier at ten times earnings.
The price of the existing stock of housing will rise as more people try to fit into less housing and rents rise to compensate. If the yield rises, the price of the asset rises too.
For the land price to rise again, income needs to rise for the earnings ratio to adjust to its natural barrier of five times earnings. Alternatively, interest could go lower. Either the numerator or denominator must change to make the equation balance. Lower interest rates are the most likely outcome. The Bank of England talking about planned future bench rate increases is ridiculous in such an environment.
The chart above shows the UK 10 year bond. Long-term the interest rate has been falling, and the face value has been rising.
The bond interest rate is closely related to the interest rate for private debt. As the stock of private debt rises, the interest rate must fall, unless earnings rise too, which they are not. While the bond interest rate has been flat to rising of late one can expect that it will fall with the rising level of private debt. The interest rate must fall if a larger stock of private debt is to be accommodated.
The British banks are arbitraging the spread between central bank reserves and the mortgage lending rate very well. This I cover in detail in this article. They pay 0.5% to borrow their reserves from the central bank and earn upwards of 4% through mortgage lending and much more on auto and credit card lending. A spread of at least 3% or better. Lending rates have room to come down and relieve the next recession and probably will.
The ruling class mostly own risk-free government bonds, and this is the market that is most closely managed and for whom the economy is run. Bizarre economic policies like austerity make sense when viewed from the perspective of a government bondholder.
Austerity makes the bond yields low; this then lifts the face value of that amount of bonds already issued. This increase in value can be sold and realized as a profit or borrowed against and leveraged into more investments.
A lot of bond portfolios are heavily leveraged, and bondholders want maximum price stability, low inflation, all the main themes one hears from the IMF, World Bank, ECB and EU, FOMC.
Now if a lot of sovereign bonds are bought on margin loans, it means private commercial banks, and their margin loan customers, are exposed to bond price movements.
On the one hand, the bondholder wants a yield and the other hand he wants a rising face value. His problem comes when the bond rolls over into lower yields and also when the bond comes close to maturity, and the face value decays back to par value. At best one rolls the bond over into a new one before the bond price decays.
The most likely outcome for bonds is a falling yield and a rising face value due to their influence on the interest rates that affect private debt, and the need for ever more private debt to be supported on static incomes, the lower the rate, the more private debt can be supported.
The chart above shows how the British stock market has traded since the low in 2009 using the ETF EWU as a proxy. If one had bought the 2009 low one would have done well. Apart from that once things had recovered to pre GFC levels performance has been less than stellar.
The reason for the poor performance is the weak money flow, and now that the money flows have turned negative, a recession and stock market bear market is the most likely outcome.
What money has been added to the British economy by way of credit creation and government spending has leaked away in imports and gone into rising house prices and not into stocks. This trend can only get worse as the money supply is reduced with austerity politics. The British stock market is more a candidate for the big short rather than a long-term investment at present. The fairly strong 4% yield is from the overweight finance sector whereby mortgage payments from households are recycled into 3-4% dividend payouts to shareholders. It is a reverse Robin Hood economy where one takes from the many and gives to the rich.
Investors wishing for access to the UK can gain exposure via the following ETFs:
- iShares MSCI United Kingdom ETF (EWU)
- iShares Currency Hedged MSCI United Kingdom ETF (NYSEARCA:HEWU)
- First Trust United Kingdom AlphaDEX Fund (NASDAQ:FKU)
- iShares MSCI United Kingdom Small-Cap ETF
- Deutsche X-trackers MSCI United Kingdom Hedged Equity ETF (NYSEARCA:DBUK)
- SPDR MSCI United Kingdom Quality Mix ETF (NYSEARCA:QGBR)
This article was written by
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