[economics 101] the reason why it must

Found myself in a position today where I had to explain my perspective to a financier whose English level was reasonable but not fabulous. His question was simple – why I thought the western economy was going to collapse.

Seems to me that there are two ways to come at this question – politically, in terms of what the ECB and Fed are up to and in terms of Economics 101, which is as much as I can lay claim to.

In 1989, a teacher's salary was J11 000 and a two bedroom semi-detached was J55 000 in the north. Seems to me today that in Britain, the salary is about J22K and the house about J120-180K. In Russia, the ratio has gone from 1:15 in 1999 to 1:26 today.

Income, in real terms, has gone down and continues to, to the point that the only way to have a house and one car is to go into deep hock. This is fundamentally wrong and has been fuelled by the availability of credit which is not even cheap.

An inevitable consequence of this is that the middle half of society moves from a position of relative equity to a position of debt and slowly drops into sub-prime status, which was most certainly not the situation in 1969.

It's further fuelled by unrealistic aspirations, the gratification of which has moved into the area of the unaffordable and whose spin-off is that people nurtured on the credit economy inevitably see credit as smart money instead of the debt it is.

The great terminological inexactitude the banks persist with is that most people can make ends meet and therefore will not exceed credit limits or seek further credit. The banks know very well that people's aspirations, fuelled by a “keeping up with the Joneses” mentality will lead them to seek “solutions” from their friendly cooperative or other provider.

Another cynical “given” is that a proportion of people will default, be it an overdraft or true default. Insurance will carry them for a while but not forever. That proportion is most certainly increasing in all western countries – I have U.S. and Australian stats on this.

Now the most unforgivable of all. In a sub-prime position, people go for finance to cover their lack of finance and are given it but at rates which are exorbitant. It should be the other way. Sound borrowers can carry higher rates but sub-primes can both ill afford to nor do they usually have the least clue how to handle money.

So the credit economy becomes the debt economy [$18, 700 per household in the U.S. In 2004, inc all debt] and as the luxuries are pared back to the bone, even basic mortgage and car repayments assume mammoth proportions.

Solution – refinancing and second mortgages.

The pressure on the housing market is enormous, the market stalls, rates go up partly due to the parallel sub-prime loan defaulting, when they should be doing the opposite, the banks themselves find themselves in an overextended position partly due to quite unsound speculative investment, the CB bails them out.

Prime borrowers are also finding themselves in trouble, as Henry Paulson recently noted:

"Yet, the problem today is not limited to subprime mortgages as the number of homeowners having trouble making payments on prime mortgages is also increasing."

Meanwhile, the banks have been quietly divesting themselves of gold and are increasingly relying on unbacked scribble in a ledger to balance the books [or not bothering, in the case of the EU – admittedly not a bank but still – see the auditor's report for 2004. for example].

While this is happening, the herd mentality has created "gold thinking" and elsewhere, Asian sovereign funds are looming mighty large, which is interesting, given today's warning [below] re the Nikkei.

This has followed on from clear warnings that U.S. financial markets reeled from a growing credit crunch, centered not in the subprime area, but in the leveraged corporate debt market. Private equity funds have become a dodo and hedge funds and derivatives have become two dirty words. Lack of transparency has also led to unease - just what is the overall strategy of the b-g--rs?

Take away property and that leaves commodities.

So, back to the mundane, the average punter is in big hock to the finance provider who, through unwise speculation on the strength of CB noises about soundness, is in hock to the CB, who in turn has been divesting itself of real money and the only ones with money are the Old Money who've been buying up for the inevitable rainy day.

Is this a healthy economy?

Now where the economists and I part company is that they say, just as they explain away the '29 crash, that 2007 is due to cloudy foresight or even incompetence. I maintain that it is due to selective blindness and that there is an agenda to destabilize, certainly from the Round Table and ECB, where my information is sounder.

The purpose? Here we get political again but a glance at the decades pre-1914 and pre-1939 show some parallels. Also, answer one question – can you afford gold anymore? You could have in 2005. So who can afford gold now? OK, it's coming down, so how much is available for the average punter to buy?

Back to the global economy and this little statement earlier today from the BBC, whose link I lost in my haste, I'm sorry:

"I'm afraid factors from overseas, such as sub-prime problems, are coming over to Japan," said Chief Cabinet Secretary Nobutaka Machimura. "We'll closely monitor the situation," he added.

"Its getting to the point where everything seems scary and that its hard to trust what financial institutions are saying."

Why would the U.S. housing crisis affect the Nikkei?

Economists will snort but I don't mean the nuts and bolts - Sackerson's report that Karl Denninger (Market Ticker, yesterday) explained it as a relativistic effect:

Our problems are bad. The problems that will be faced overseas are FAR WORSE. Overseas economies are dependant on us, not the other way around. When this sinks in the other currencies against which the DX is measured will collapse; this will appear to raise the dollar, but in fact it is the sinking of other currencies.

No, I mean, in very non-economist terms, why would the market operate in such a way anyway that this could happen in the first place? What sort of a market fails to be gear itself to prevent this? I'm not talking cause and effect here – I'm asking this question in the way Guthrum asks why we even need government at all. Fundamental structural principle.

I say there are only two explanations for the crisis in the U.S. which the FOMC was meant to prevent:

1. Incompetence – not foreseeing logical consequences – in which case it's very worrying that the world economy is at their beck and call;

2. Design – selective failure to act, allowing sub-prime lending to the point where the sheer volume creates crisis nd tweaking interest rates to exacerbate the situation - in which case it's very worrying that the world economy is at their beck and call.

For example, they were well aware of the likely housing outcome in October, 2006:

Residential construction activity remained weak. Single-family starts ticked up in September, but new permit issuance slid further to its lowest level in nearly five years.

Now, look at one further aspect. Ben Bernanke explained the Fed's recent actions by saying a central bank has to do things that will prevent sales of assets that "will drive the prices of those assets well below their longer-term fundamental values, raising the risk of widespread insolvency and intensifying the crisis."

And what if the fundamental value is far less than supposed? Then the Fed would be fuelling a bubble. And we all know what happened last time. Now is this incompetence or design? We could argue this one till the cows come home.

So where does that leave the average punter? It leaves him paying out, selling off and buying up commodities, which themselves are being selectively released onto the market, with the pittance he's left with.